An Investing Group You Don't Want to Join

I get depressed whenever I read an article about advisors who lose a large amount of money belonging to athletes. This one is typical. An ex-financial adviser apologized for losing $43 million of his clients' money. All of his clients were NFL players.

He invested their money in "an entertainment and gambling center", which included electronic slot machines. These machines were illegal at the time.

Athletes are often victims

Athletes are easy prey and often fall victim to bad advice and outright scams. By one estimate, 60 percent of pro basketball players are broke within five years of retirement.

Clearly, you don't want to be in a club that invests like pro athletes. That's an easy decision. Here's a more surprising one.

Rekenthaler's position on active management

John Rekenthaler is Vice President of Research for Morningstar. Morningstar is a leading source of independent research on stocks and mutual funds. Many institutions and individual investors rely on its research when selecting stocks and mutual funds for their portfolios.

In an article published on October 21, 2016, Mr. Rekenthaler wrote:

"In Tuesday's article "The Dying Business of Picking Stocks," The Wall Street Journal all but buried active stock management. According to the Journal, the great mutual fund battle is over. The index funds have won, leaving actively managed funds reeling for the foreseeable future.

That is correct."

Mr. Rekenthaler offered different strategies for active fund managers to survive. They included discounting fees (which he did not think would be sufficient), give up stock picking and focusing on putting together portfolios that invest in stocks that share common attributes, and creating funds that offer "solutions", like "target-date funds, managed-payout funds, global-allocation funds, and targeted-income funds."

Inflows and outflows

The ramifications of these observations are profound. Most individual investors still use brokers who tell them (with no credible evidence to support their views) they can "beat the market" through stock picking, market timing and selecting outperforming active fund managers. Rekenthaler agrees with those of us who have been beating the drums in the opposite direction for many years.

A recent article in Forbes by Kate Statler nicely summarized the evidence of underperformance by active fund managers when measured against their index benchmark.

Investors aren't dumb. They are voting with their wallets. Active U.S. funds suffered an outflow in 2015, while passive U.S. funds attracted about $400 billion in flows, according to Morningstar's global asset flows report, published on March 22, 2016.

Institutions take notice

Institutional investors aren't dumb either. They're taking a hard look at this evidence and deciding they don't want to participate any longer in the process of trying to select active fund managers who can consistently beat the market. The Wall Street Journal published an article about the $35 billion Nevada's Public Employees Retirement Plan.

When Steve Edmundson, the current Chief Investment Officer of the plan was hired as an analyst in 2005, about 60 percent of its stocks were in index funds. When he was promoted to CIO in 2012, he started replacing active funds with passive ones. By 2015, 100 percent of its stock and bond investments were in index funds.

The expenses of the fund were cut from an estimated $120 million to $18 million. The returns of the Plan have been stellar, beating those of the California Public Employees' Retirement System, which is the largest public pension in the country, and many other plans with high priced consultants and complex investment strategies.

There are many reasons why other public pension plans don't follow Mr. Edmundson's lead. None of them relate to investment performance. There is overwhelming evidence that most state pension plans underperform a simple index based portfolio. It seems that politics and lobbying prevents plan sponsors from following this data and changing their investment philosophy.

Ramifications for you

You're not similarly constrained. Don't succumb to the massive advertising and the smug predictions of self-styled experts who encourage active trading. If you're using a broker, it's likely you're following an investment strategy that has been largely discredited.

Being with other gullible investors who ignore the evidence is not an investing club you want to join. If you're already a member, it's time to depart.

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.