The Actively Managed Trap

We've heard it before, and we'll hear it again, because not everyone has gotten the message. It's very difficult for actively managed mutual funds -- those funds run by a team of analysts and managers who pick the investments -- to beat the overall stock market.

This is once again emphasized in a new tome, The Great Mutual Fund Trap: An Investment Recovery Plan. Written by Gregory Baer and Gary Gensler, former U.S. Treasury officials, the book argues that actively managed funds cannot overcome trading fees, management expenses, sales commissions, and marketing budgets.

According to Baer and Gensler, the 1,226 actively managed stock funds with a five-year record by the end of 2001 posted an average return of 8.8% a year -- 1.9 percentage points behind the Standard & Poor's 500. The 623 actively managed stock funds with a 10-year record returned 11.2% annually, on average, vs. 12.9% for the S&P 500.

This doesn't count funds that operated during those time periods but were closed, usually due to poor performance. The authors argue that this "survivorship bias" hides the fact that the average actively managed mutual fund underperforms the market by approximately three percentage points a year.

Want more stats? The average actively managed fund underperforms the market three out of every five years. And guess how many funds have beaten the S&P 500 each of the past 10 years. Just one: the Legg Mason Value Trust.

The Great Mutual Fund Trap likens trying to beat the market to flipping a coin and hoping to always get "heads," as shown in this excerpt (courtesy of BusinessWeek):

Imagine, then, the Coin Flipping News Network (CFNN), giving us 24-hour daily coverage of the flipping market. In comes coin-flipper Lee with 56 heads, touting her latest tactic -- say, many revolutions of the coin, with three taped together. Long forgotten is last week's guest, who had favored the few-revolution, one-coin-at-a-time tactic that worked so well during the last 500 flips but is now seriously out of favor. "Momentum" viewers prefer those who have recently had more heads, while "value" viewers like those who have recently had more tails.

Above all, viewers are assured that they are not capable of flipping the coins themselves -- that they must rely on the experts to do it for them. And they are convinced that they should never be satisfied with just 50% heads -- that is, "market" performance.

What's the solution? Indulge in the simplicity and cost-effectiveness of an index fund. It doesn't try to outperform the market, which means it won't grossly underperform it -- a feat accomplished by few actively managed funds.

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