Fifteen years ago, when asked about the value of active versus passive investments, I would have told you that I preferred active managers.
Actively managed funds are funds that have someone at the helm making decisions. Everyday people are deciding what to buy and what to sell. The idea that someone smart is looking after my money is comforting. Someone is there to protect me if things go wrong, and someone is there to take advantage of market inefficiencies to make me money when things go right. On an emotional level it makes sense and it feels good.
The problem is emotions don’t really work that well in an investment program. Today, if you asked me the same question I would say I lean strongly toward passive investing. Not exclusively, but I give it a strong preference. Passive investing is simply defining the universe of investments that you want to invest in and buying all of them.
What has changed in the past 15 years? It is true that markets have become more efficient, and that means there is less to take advantage of for an active manager. But that isn’t the main reason I have changed. I have changed because we now have 30-plus years of data that support the fact it is very difficult to find active managers who really make a difference.
Eugene Fama, who won the Nobel Prize for Economics, has done extensive research on this topic. I have been lucky enough to have spent time with Dr. Fama on several occasions, most recently last week in Chicago. He says if you took all of the active managers who performed in the top half of their universe and looked at their results, you could attribute their excess performance to luck in all but 2 percent of the cases. Even those 2 percent will have long periods of underperformance that will make even the most disciplined investor want to sell. His research also showed it would take about 37 years of data to determine if a manager was lucky or not. He said even the top 2 percent have a hard time beating their index because they get paid more for being good and that comes out of their net performance. So, even if you are able to select the right manager, your chances of keeping them during periods of poor performance are slim, and if you do, you are likely to pay them so much in fees that their net performance will be very close to that of the index they are trying to beat.
So it comes down to this for me: Chances are that you will pick one of the bottom 98 percent of managers who are either bad or currently lucky. If you get one of the top 2 percent, you will probably pay too much in fees and end up looking like the index. Why not just buy the index and pay much less in fees? At the end of the day you can’t control future performance, but you can control fees. It’s something to think about.
Scott Reed is CEO of investment advisory firm Hardy Reed in Tupelo. Contact him at (662) 823-4722 or firstname.lastname@example.org.