People often struggle with the concept of average. Particularly us Anglo-Saxons. It’s instilled in us from an early age that we must do our best — and be the best we can at whatever it is we do. If you’re anything less than well above average you’re a loser.
We naturally like to think we’re better than most — better drivers, bloggers, lovers or whatever it may be. We’re like the inhabitants of Lake Wobegon, the fictional town in Minnesota “where all the women are strong, all the men are good looking, and all the children are above average”. Of course the blunt truth is that we can’t all be above average. In aggregate, average is precisely what we are.
When Jack Bogle, the founder of Vanguard, launched the first retail index fund on New Year’s Eve 1975, he was derided by the mutual fund industry. The fund was lampooned as “Bogle’s Folly” and was even described as “un-American”. Why? Because no one could see why investors would be happy to “settle for average”.
An executive of the National Securities and Research Corporation said: “Who wants to be operated on by an average surgeon?” In a similar vein, Edward Johnson, the chairman of Fidelity, remarked: “I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns.”
Bogle’s critics were in fact being thoroughly disingenuous. In aggregate, average returns were just what investors were already receiving. But, far worse, after fees and charges, those average returns were considerably smaller than the average returns delivered by the markets.
Of course, you can’t invest directly in, say, the S&P 500; you have to do it via an index fund, which will inevitably charge for its services. Thankfully, the fees charged by index funds are very much lower than the costs entailed with using actively managed funds.
You also need to consider tracking difference which, in effect, is another cost. There is a fund in the UK, L&G Index I, which has actually beaten the return of the FTSE All-Share by 0.05% per year and effectively paid you for owning it; admittedly that’s rare, but you can easily find a fund nowadays with a negative tracking difference of fewer than 10 basis points.
Ultimately, it’s the huge disparity in the costs entailed with active and passive investing that makes all the difference. As the Nobel Prize-winning economist William Sharpe explained in his 1991 paper, The Arithmetic of Active Management, the investing community is divided into two — active investors and passive investors. Before costs, the return on the average actively managed pound/ euro/ dollar will equal the return on the average passively managed dollar. After costs, however, the return on the average actively managed pound/ euro/ dollar must be less than the return on the average passively managed dollar. Therefore, the average active investor must — no ifs or maybes, must — underperform the average passive investor.
This isn’t a theory; it’s mathematical fact. To quote Professor Sharpe: “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”
“Ah,” your adviser might say, “don’t worry, I’m a good adviser and I only pick the best funds”. What he usually means is that he can tell you which active managers have outperformed in the past. Alas, past performance gives very little clue, if any at all, as to future returns. Picking star managers ex ante — in other words, before they start to outperform — is all but impossible. On average, by definition, advisers pick average funds, and the average fund doesn’t even cover its costs.
It’s the same with fund managers. The impression they want to give is that they only provide good funds. The way they do it is by constantly launching new products, hence the extraordinary situation that exists today in which there are more funds than individual securities. If a firm has hundreds or thousands of funds, then a few of those are likely to outperform by the law of averages. And guess what? Those are precisely the funds that feature in their advertising and that you read about in the media.
Funds, on the other hand, that consistently underperform are either merged with other funds or quietly closed. 55% of domestic equity funds available to UK investors ten years ago, for example, don’t even exist today.
Such is the current crisis in active management, however, that not even flooding the market with funds can guarantee a fund provider that it will produce some winners. How many of Fidelity’s 138 actively managed US large-cap funds, for instance, have outperformed its S&P 500 index fund over the last five years? Zero. No one at Fidelity laughs at Bogle now.
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