A case against active fund management - Part 1

We all love to find a good deal. We go at great length to save a few cents/dollars on various items and services. We religiously participate in several rewards program, subscribe to 'Groupon', visit 'Catch of the day', collect vouchers to save a few cents on grocery items, drive several kilometers to save a few cents on petrol prices and spend weekends trying to find the best price on airline tickets, hotel booking among other things. And, we grumble every time government marginally increases direct/indirect taxes like $7 GP co-payment (now $20 GP fees).

Yet, when it comes to our retirement savings (Superannuation), we don't seem to care. Majority of us have no idea about our superannuation balance, where its invested or the associated costs. Based on the internal data from Australian Taxation Office, as of 31st Dec 2013, the total lost super figure in Australia sits at a staggering $18.1 billion. Westpac's 2013 report on superannuation estimates the average amount of lost super per person in Australia is $2,592. (This modest amount compounded over 40 years at 11% annual return comes to an amazing $168,482.) We all seem to realise that we are living longer (average life expectancy is 85 years) and will require retirement savings to support us for 25 years on more. Despite all this, why is it that we don't seem to care about the all important retirement savings (Superannuation)? Firstly, because retirement seems far away, it feels absurd to be fretting about something that will not needed for another 30 or possibly 40 years while we have more urgent things to attend to NOW!. Secondly, most of us lack the expertise to invest in stock markets and believe it is best left to the experts - the fund managers.

Fund managers are the so-called experts at investing. Using their expert knowledge, they invest money on our behalf in return for a fees. They decide which stocks to buy, when to buy and when to sell. Without a doubt, the fund managers are very well remunerated. But, here's the catch, evidence from various academic studies conducted across the world conclude that only 1% (very tiny fraction) of the fund managers were able to outperform the market on a consistent basis. Take the bonuses, fees and operating cost into consideration, it leaves nothing for the entrusting investor.

In other words, 99% of the fund managers fail to beat the market, but continue to charge (excessive) high fees. Fund management companies charge around 1.6% on an average for asset under management. Let us consider the impact of high management fees, in a highly unlikely, but optimistic scenario that a fund manager manages to match the market returns.

Amount CAGR Years Returns (fees @.05%) Returns (fees @ 1.6%) Difference
$10,000.00 11% 5 $16,812.66 $15,670.64 $1,142.03
$10,000.00 11% 10 $28,266.57 $24,556.88 $3,709.69
$10,000.00 11% 15 $47,523.63 $38,482.19 $9,041.43
$10,000.00 11% 20 $79,899.88 $60,304.04 $19,595.84
$10,000.00 11% 25 $134,332.98 $94,500.27 $39,832.71
$10,000.00 11% 30 $225,849.53 $148,087.93 $77,761.60
$10,000.00 11% 35 $379,713.23 $232,063.20 $147,650.03
$10,000.00 11% 40 $638,399.10 $363,657.78 $274,741.32
$10,000.00 11% 45 $1,073,318.95 $569,874.85 $503,444.10

Due to the nature of how compounding works, high fees charged by fund management companies, end up making a very significant difference in total returns achieved by the investor. It would be perfectly reasonable to accept higher costs and charges if the fund managers were adding value over and above the market returns but evidence suggest otherwise.  For a majority of investors,it is not worth paying a huge sums to money to fund managers to actively manage their investments. When it comes to investing - less is more. The less we pay in fees, the more we get to keep.

As mentioned before, evidence from the reports and studies, do conclude that a tiny number of star performers exist, but it is incredibly difficult to identify them at the outset. Of the 1% of the fund managers, who manage to outperform the market consistently over large period of time, it is very difficult to identify them in advance. Based on studies, the odds of identifying a star manager in advance are comparable to winning a lottery. Fund management companies work hard using tactics like lobbying, advertising and support from financial media to keep the average investor in the dark, and so far has been quite successful at it.

In terms of simple arithmetic, active investing is fundamentally a zero sum game (without fees and charges). Every trade involves two parties - a buyer and a seller. For every buyer (who believes that the price of the asset is going to up) there exist a seller (who believes that the price of the asset is going to go down). Since only one of them can be correct, it implies that for every winner there is a loser. It is no wonder then, the so many fund managers fail to outperform the market. When we add the fees charged by the fund management companies, it ends up becoming a negative sum game. Ultimately, it is the individual/retail investor who pays for it!

Before the advent of the Internet, big institution had playing field tilted in their favor. It used to be that big institutions would receive information first, get to see the company first, meet the management and ask intelligent questions while the average investor would be kept in the dark. Institutions no longer enjoy such advantages. It is no surprise that it is has become near impossible for majority of the fund managers to outperform the market.

So, what does all of this mean for the retail/average individuals? An average individual will be way better of with investing in a low cost index fund that tracks the entire market. Or in the words of legendary investor John Bogle, "What is the intellectual basis for indexing? Gross returns - cost = net returns. What is the intellectual basis for active management? I ve never heard one. The closest I have come is a manager says - I can do better. They all say I can do better, but probably only about 1% actually do better"

Investing in index funds will us help sleep better, enjoy life and can produce very satisfying results, if only we stay the course.

In the next article, I will focus on the rational (academic research) behind investing in index funds.

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