Luke Delorme | Money Talk: The math that hurts active investors

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GREAT BARRINGTON >> Investors have to choose between funds that are actively managed and those that are passively managed.

Active management involves selecting individual stocks or timing the market just right in an attempt to do better than everyone else. An active mutual fund manager might analyze all of the stocks in the S&P 500 and pick the 50 of them that he believes will outperform the rest.

Passive management simply means choosing a whole universe of investments and letting it play out over long periods of time. Passively managed funds, for instance, will buy all 500 stocks in the S&P 500 instead of trying to pick the best 50 of them.

Although active management seems like a great idea on its surface, active investors have often found themselves lagging passive ones. Even highly trained and clever financial pros regularly underperform simple, passive strategies. Or, to put it bluntly, monkeys could do better than these guys.

One of the reasons may be that active managers have a hurdle that necessarily detracts from their performance. That hurdle is the fees that they need to charge.

Every trade of stock represents a buy and a sell. That means that every transaction that takes place in the stock market must have a "winner" and a "loser." If we assume that active investing constitutes the bulk of trading activity, we can assume that these winners and losers will net out in total. That means that the average gains of all active investors will be identical to the average gains of passive investors.

However, active investors incur higher costs than passive investors in the form of transaction costs, research costs, and fund management costs. Actively managed mutual funds routinely charge between 0.5 and 2 percent.

Passive investors have implementation costs, but they don't need to pay a professional to try to evaluate and select which stocks will do better. Some passive Vanguard funds can charge annual fees as low as 0.05 percent.

The math is simple. If active and passive investors get the same average return before fees, then we can expect that passive investors will do better on average after fees.

This doesn't mean that any single actively managed fund won't beat a similar passively managed one. In fact we know with certainty that many will beat the average in any given year. The problem is, the data show that these "winners" may come out on top simply due to chance, rather than skill. Trying to identify the winners in advance is a loser's game.

Investors on average are better served by selecting low-cost, passive funds. In the last five years, we've really seen performance swing in favor of passive investments. During this time, only about one in four actively managed funds beat it's passively managed counterpart. If you happen to be in that one fund, then you've managed to do well, but the deck is stacked against you.

It's a bit like going to Las Vegas. Maybe you hit on the roulette wheel a couple of times and you're up a few hundred dollars. But we all know that if you play long enough the house is going to win out over time. While it may be possible to pick winners, it doesn't usually pay to play a game that loses on average.

Luke Delorme is the director of financial planning at American Investment Services (AIS) in Great Barrington. He can be reached at luked@americaninvestment.com.


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