Investing in the stock market is often a matter of luck, but it's also a matter of skill. Some professional money-managers spend years studying statistics and trends in an effort to time the market just right, and some scour the market for hidden gems, poring over companies' SEC filings for hours on end. Investors who prefer this sort of rigorous approach often turn to actively managed funds.
The downside of actively managed funds is that they charge fees that can eat away at your returns. The upside, however, is that when you invest in an actively managed fund, you can benefit from the expertise of those who run it.
At least, that's what those fund managers would like you to believe.
And yet a few years back, a group of so-called professional investors faced off against a household cat to see whose stock picks generated a higher return. The winner? That would be the cat.
Just a guessing game?
Back in 2012, a British newspaper pitted a housecat named Orlando against a team of investment professionals to see whose stock picks would outperform the other's. The experts -- including a wealth manager, a stockbroker, and a fund manager -- chose companies to invest in based on their combined decades of expertise and knowledge of the market. The cat, meanwhile, selected his stocks by throwing his beloved toy mouse on a grid of numbers, each of which was assigned to a different company. Both teams started out with $8,000 to invest, and over the course of a year, Orlando's portfolio grew to about $8,900 while the experts' portfolio grew to roughly $8,300.
Of course, the results of this little face-off should be taken with a grain of salt. The experiment itself was conducted over the course of a year, which is a pretty narrow time frame in the grand scheme of investing. Plus, we don't know exactly what pool of stocks our pal Orlando was choosing from. In other words, just because a cat beat the experts this one time doesn't mean that all money managers are useless. But it does cast some doubt on the benefits of active management funds -- especially since this isn't the only instance of an animal outperforming the experts.
Back in 1999, a chimpanzee named Raven picked stocks by throwing darts at a board. Her portfolio ultimately outperformed over 6,000 money managers by scoring a whopping 213% return for the year. And years later, a Russian circus chimp named Lusha assembled a portfolio that beat 94% of Russia's mutual funds. Kind of makes you question the benefit of paying the experts.
Actively managed funds versus index funds
These various animal experiments are entertaining but sobering examples of how actively managed funds may not be all they're cracked up to be. In fact, there's plenty of data suggesting that most investors would be better off putting their money into index funds instead. Unlike actively managed mutual funds, index funds are passively managed; they simply seek to track and match the performance of existing indexes, such as the S&P 500. Because they don't come with the same hefty fees as most actively managed funds, index funds are often the more economical choice for investors. According to a 2015 Morningstar study, between 2004 and 2014, index funds outperformed actively managed funds across nearly all asset classes.
Naturally, this begs the question: If actively managed funds can't outperform their passively managed counterparts, then what exactly are investors paying for?
When better returns come at a cost
While there is data showing how index funds have beaten actively managed funds in the past, this isn't to say that all index funds outperform all actively managed funds. There are always some actively managed funds that beat the returns of index funds -- sometimes by significant margins. But as an investor, you need to look at more than just your average return. You should also weigh that return against the fees you've paid to get there. And it's not uncommon for an actively managed fund's outperformance to be reduced or eliminated completely when you factor in those fees.
Choosing the right investments
So here's what you can learn from all of this: While actively managed mutual funds may be right for some people, the average investor stands a good chance at coming out ahead by focusing on index funds instead. If you're just getting started, you might consider the Vanguard S&P 500 ETF (NYSEMKT:VOO) or the Vanguard Total Stock Market ETF (NYSEMKT:VTI), both of which come with low fees.
Of course, actively managed and index funds aren't mutually exclusive, and depending on your circumstances, there might be a place for both in your portfolio. Just don't throw your money into actively managed mutual funds thinking those high fees are guaranteed to bring you a higher return. You might be better off rolling the dice and seeing where they land.
Or getting a cat to do it for you.