A $2 Trillion Mistake

A $2 Trillion Mistake
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If you’re like most investors, your primary goal is to maximize your returns for a given level of risk. A new report from Morningstar is bad news for investors who tried to accomplish this goal in actively managed funds holding over $2 trillion in assets.

Factors to consider

The report notes investors who are considering an actively managed fund should focus on these two factors:

1. The annual management fee charged by the fund; and

2. The potential of the fund to generate returns before fees in excess of its benchmark index.

It’s easy to determine the management fee of any fund. It’s referred to as its “expense ratio” and is set forth in the prospectus and on financial web sites, like Yahoo Finance.

Study results

The study analyzed 6,708 U.S. stock funds. It concluded that 4,635 (two-thirds of them) were projected to underperform their benchmark, net of fees. This underperformance was due to the amount of fees charged by these funds. The report found: “At their current price, and assuming those estimates approximate actual pre-fee excess returns in the future, these funds would have no prayer of beating their benchmarks after fees.”

The reality, as found by the study, is that “most active U.S. stock funds are too expensive to succeed.” Even the actively managed funds with lower fees, and projected excess returns, have “little margin of error”, making their outperformance far less than a sure thing.

The one silver lining for investors in actively managed funds was small cap funds “where it appears fees are still below estimated future pre-fee excess returns.”

The report had this advice for active fund managers (which is unlikely to be heeded): Slash fees or mothball the funds.

The active share myth

Actively managed fund families are not taking all this negative publicity in stride. They are fighting back with purported ways savvy investors can prospectively identify actively managed funds likely to outperform. One of the most publicized of these tools is “active share.” This theory holds that fund managers who's holdings deviate the most from their benchmark index (measured by “active share”), “are well positioned to outperform their benchmarks before and after fees.”

If this was true, all you would have to do is purchase actively managed funds with the highest active share, and you could be confident of achieving returns in excess of its benchmark index.

If only it were that easy.

Vanguard reviewed the data in this analysis. Initially, it found funds with a high active share score had at least as much downside as upside, meaning that you would need to hold on to these funds for the long term and withstand periods of underperformance.

It then identified actively managed U.S. stock funds that ended 2009 with a high active share score of at least 80 percent. It compared the returns of these funds during the five-year period from 2005-1009 and then calculated the returns for the ensuing five-year period from 2010-2014.

It found that funds with a high active share score in 2009, that performed in the top quartiles during the prior five-year period, turned into underperformers in the next five years.

Clearly, high active share was not a predictor of future outperformance.

A better way

Don’t be enticed by the hype about achieving outsized returns using actively managed funds. There’s no reliable way to select outperforming funds prospectively, even by using active share as a measurement. As the Morningstar report illustrates, most actively managed funds are priced to fail. Even those that aren’t have little room for error.

Your expected returns will likely be higher if you refuse to play a game that primarily enriches mutual fund families and brokers. Instead, confine your investments to low management fee target date funds, LifeStrategy funds from Vanguard, index funds and exchange-traded funds.

It’s time to focus on your retirement instead of transferring your money to those who “manage” it.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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