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Your Chances with Active Management

Most investors would rather climb Mount Everest than invest their money in actively managed funds. At least that’s what could be deduced from research that shows investors don’t like their chances of beating the market. Meanwhile, the Vanguard  study ‘Building a global core-satellite portfolio’ demonstrates that active funds, over time, offer extremely low odds of doing just that.

The 2nd quarter 2013 “Investor Watch” survey by Swiss bank UBS found, “With investors remaining more concerned about avoiding losses (70%) than missing out on market gains (30%), this translates into taking an investment approach that is no longer about beating the market.” Additionally, “investors remain focused on achieving financial goals within the context of avoiding risk.” This seems to indicate that the probability – rather than the possibility – an investment can produce a positive return is a growing factor in investors’ decision making.

That’s bad news for actively managed mutual funds. Consider that this Vanguard study shows that just 1 in 20 investors could select a portfolio of active funds that outperformed the market index over a 20-year period. That is only a 5% chance for success, or a whopping 95% chance for failure.

Since we, as humans, attain a better perspective through comparison, let’s see how those 1 in 20 odds stack up against the odds of other potential events:

  • Being diagnosed with cancer in your lifetime: 1 in 2 for men, 1 in 3 for women
  • Beating the house in a hand of blackjack: 1 in 2.2
  • A celebrity marriage lasting a lifetime: 1 in 3
  • Successfully climbing Mount Everest: 1 in 3
  • Living to 100 (if you’re 50): 1 in 8
  • Being selected on “The Price is Right”: 1 in 36

That means, if you chose to invest in a portfolio of active funds for the long run, your odds of outperforming the market would be worse than summiting the highest point in the world…but better than being called to “come on down!”

Furthermore, in a study published in the Journal of Finance by Laurent Barras, a finance professor at McGill University in Montreal, only 12 out of 2,076 – 0.6% – actively managed funds studied showed the ability to consistently add value, after expenses, from 1975 to 2006. Those odds are only slightly better than the 1 in 200 (0.5%) that you’re a direct descendant of Genghis Khan (if you’re male). While that may mean some funds are capable of consistently beating the market over time, what are the odds you can successfully pick which funds are in that 0.6%?

So, what explains the low probability that active funds consistently outperform the market? In addition to a fund manager’s inability to accurately predict the future over time, the reason is high costs. To actually outperform, the fund not only has to beat the market but also by a large enough margin to cover costs.

Cost is also a disadvantage of active funds when compared to index funds. According to the Investment Company Institute (ICI) 2014 Fact Book, the average expense ratio for actively managed funds is 0.89% compared to index funds of 0.12%. From that start, the average actively managed fund puts you at a 0.77% disadvantage against the average index fund. That disparity in expense ratio helps explain why, as Vanguard states in “The Case for Index-Fund Investing,” “low-cost index funds have displayed a greater probability of outperforming higher-cost actively manage funds.”

Lower costs may help increase the probability investors reach their investment goals by letting investors keep more of their return. Therefore, it shouldn’t come as a surprise as to where investors have been moving their money. From 2007 through 2013, according to the ICI, cash outflows from actively managed U.S. stock funds reached $575 billion while U.S. stock index funds and index-based exchange-traded funds experienced cash inflows of $795 billion.

Of course, the long odds – no matter how unfavorable – of a positive outcome likely won’t prevent people from trying to beat the market. After all, people still repeatedly try to win the lotto, which, in case you’re wondering, has the odds of 1 in 135,145,920.

But, when you’ve worked hard to accumulate money that you hope grows and lasts over your lifetime, the thought of investing in active funds may give you pause and cause you to wonder, “Do I really like these odds?”