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Why Active Management Doesn’t Win

Nobel laureates in economics as well as many investment greats such as John Bogle, Warren Buffett, Eugene Fama and David Swenson have been telling us for decades that index investing is a better strategy for most investors.

High expenses are the primary reason why most actively managed mutual funds underperform index funds. The more you pay in investment costs, the lower your long-term returns are expected to be. William Sharpe, Nobel Laureate in Economics Sciences, eloquently states this point in his timeless article, The Arithmetic of Active Management.

Sharpe’s argument is intuitive. According to the Investment Company Institute's 2013 Fact Book, mutual funds are a $13 trillion dollar business, and that is more than one-third of the value of the entire U.S. stock market. As such, mutual funds in aggregate can only return what the entire stock market returns, less costs.

Over the long-term, it is almost impossible for actively managed mutual funds to charge more and earn more. The average actively managed fund will usually underperform the average passively managed fund over time because they charge seven times more in fees.

According to biannual SPIVA Scorecards from S&P Dow Jones Indices, an analysis of returns shows that only about one-third of actively managed mutual funds outperform index funds each year and over time that number decreases to only a handful. The problem is that it is not possible to identify in advance which active funds will deliver superior returns. Past performance is not a reliable predictor of future returns. Often top ranked actively managed funds in one period become bottom ranked funds over the next period.

Further analysis points to fund expense as a reliable factor in estimating long-term mutual fund performance. The figure below illustrates that large actively managed U.S. stock mutual funds with high fees performed below actively managed funds with low fees, and both performed less than the index funds with the lowest fees.

Large Cap US Equity Funds - 10 Years Ending in May 2014

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