I’m not a fan of actively managed funds. I would never say never use them, but the evidence is overwhelming and categorical that, almost invariably, your net returns will be bigger if you don’t. The average active funds investor must expect to lose, relative to the average passive investor.
I realise, though, that some people, for whatever reason, will want to dabble in active investing. Even Jack Bogle has suggested that those who can’t help themselves might want to set aside 5% of their portfolio as “funny money”, to invest in whatever they fancy.
For me, if you absolutely insist on buying an active fund, you should at least go about it in an evidence-based way. Active funds.
Before looking at what does work with fund selection, let’s start with what doesn’t. The most common mistake is to base your choice on past performance. The fund industry knows that most people have an instinctive preference for recent winners. The funds it generally advertises are those which have outperformed over the last three years. They’re also the funds that are most likely to be featured in the media.
But numerous studies have shown that those are just the funds that investors ought to avoid. A new study in the US has found that it’s better to select a fund that has recently performed poorly than one that’s done well.
So, you should generally avoid the funds that everyone’s talking about. You should also pay little or no attention to recommended fund lists provided by brokers and fund shops. How can you be sure which criteria have been in used in compiling those lists, or what inducements funds have offered to be included on them?
What criteria, then, should you use in choosing an active fund? The most important one is cost. The cumulative impact of fees on net returns can be colossal. The higher the charges, the harder it is for a manager to deliver net-of-fees performance. When choosing between two funds you need to have a very good reason not to go for the cheaper one.
That US study I referred to helpfully lists a number of academic studies that have provided other useful pointers to future performance. A key consideration, say the report’s authors, is the theoretical soundness of the “investment thesis” that drives a fund’s portfolio management strategy (Cornell (2011)).
Other characteristics of a fund, the researchers say, which may indicate that it’s more likely than average to outperform in the future, include:
- the presence of performance-linked bonuses in fund manager compensation packages (Ma, Tang, and Gómez (2015));
- a high level of fund manager ownership (Khorana, Servaes, and Wedge (2007));
- board of director ownership (Cremers, Driessen, Maenhout, and Weinbaum (2009));
- a high active share (Cremers and Petajisto (2009), Amihud and Goyenko (2013));
- lack of affiliation with an investment bank (Hao and Yan (2012));
- outsourced execution of shareholder services (Sorhage (2015));
- the presence of a short-term redemption fee (Finke, Nanigian and Waller (2014));
- having PhDs in key portfolio rôles (Chaudhuri, Ivkovich, Pollet, and Trzcinka (2013)); and
- having a strong positive firm culture (Heisinger, Hsu and Ware (2015)).
The problem for an ordinary investor is that researching the welter of funds available and assessing them on each of these criteria takes a huge amount of effort. Not all of this information is readily available. Do you really have the time (and the patience) to do the research yourself? Active funds.
Of course, there are plenty of financial advisers who claim to have the ability to identify future outperformers. Sadly though, in my experience, the vast majority have little interest in, let alone grasp of, the required level of detail.
Institutional investors tend to employ consultants to recommend funds for them. But the track record for investment consultancy is truly shocking; in most cases the managers who are fired go on to outperform the managers hired to replace them.
Yes, there is a small number of good consultants out there, but think about it. Identifying future outperformers is extremely valuable and fiendishly difficult. If you’re any good at it, you’re going to exact a substantial charge for your services.
And there’s another complication. If you invest in a portfolio of index funds, then apart from rebalancing, there’s very little maintenance required. But if you invest in active funds, and you want to do it properly, you need to monitor your fund on an on-going basis. For example, is your manager still investing in his own fund? Has the active share fallen? Is the firm’s culture as strong as it was? Also, when the star manager you’ve so cleverly selected in advance starts to outperform, will he simply raise his fees accordingly, wiping out any value he adds?
Then, of course, there’s manager turnover, which has recently been on the increase. The chances that the same manager will still be running your chosen fund 30 years from now are very small.
So, there you have it — the evidence-based approach to active investing. Anyone want to try it? I’d be surprised if you don’t have more valuable and enjoyable things to do with your time.
Related posts:
The basic arithmetic the fund industry won’t acknowledge
Which of these three funds would you choose?
Where are the customers’ Porsches?
What useful function do investment consultants serve?
Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.
