A Required Warning On Actively Managed Funds

We're all familiar with the graphic warnings required on cigarette packaging and advertisements in the United States. These warnings have had the desired effect, in the U.S. and in other countries that have adopted a similar policy. They have increased knowledge of the hazards of smoking, increased short-term cessation and reduced smoking prevalence.

This practice could also protect those inclined to purchase actively managed funds.

The warning

I define "actively managed funds" to mean mutual funds that tout their ability to beat a risk-adjusted benchmark (like the S&P 500 index) by actively managing the fund's portfolio.

Here's the warning that should be prominently placed both on the first page of the prospectus for the fund and in a waiver that every investor in these funds would be required to sign before buying them:


The evidence is compelling

The evidence that supports this mandatory disclaimer has increased from a trickle to a flood. For much of it, investors owe a debt of gratitude to Larry Swedroe, the director of research for Buckingham Strategic Wealth (with whom I was previously affiliated).

In a recent blog post, Swedroe reviewed the evidence showing the daunting odds of an actively managed fund outperforming its index fund counterpart. He noted the percentage of active managers able to add significant value (known as "alpha") has "fallen from about 20% 20 years ago to just 2% today."

He attributes this precipitous drop to much tougher competition and better technology that more quickly disseminates information.

The harm caused investors who buy actively managed funds in the elusive quest for alpha is staggering. According to one study, these investors are transferring about $80 billion annually (calculated at the time of the study) from their pockets into the pockets of those who market and manage actively managed funds. The wealth transfer is larger now because U.S. market capitalization has increased to about $20 trillion.

Dismal track record of actively managed funds

In a series of blog posts, Swedroe analyzed the performance of sixteen major fund families and compared their returns to index funds sold by Vanguard and passively managed funds from Dimensional Fund Advisors. The result of his analysis is summarized here.

The results are a disaster for active management. Almost all of the fund families underperformed Vanguard and Dimensional funds from the same asset classes.

Swedroe's conclusion is unequivocal: "Given that, each year, the active management industry likely transfers more than $100 billion in funds out of the wallets of investors, it's not hard to make the case that investors and the country as a whole would be better off if much, but not all, of the industry disappeared."

Investors need this protection

Investors, like cigarette smokers, have demonstrated an inability to resist massive advertising (much of it misleading) from the tobacco and securities industries. They need the protection only the Securities and Exchange Commission can provide.

The need is here. Do we have the political will to do 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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