Let’s start with an elementary finance fact:
- A large majority of investment fund managers will underperform the market over time.
Call me a nerd, but I find this statement entirely fascinating. The reason people allocate them savings to asset managers, such as mutual funds, is because they are the investment professionals. Yet, as a cohort, the generate a lower return on investment compared to an index that tracks the general performance of stocks over time. In fact, studies have found that ratios of underperforming active fund managers reach levels over 95% of the cohort.
How is that even possible, you ask yourself? The short answer is fees. All funds – mutual funds, pension funds, hedge funds, etc – are businesses and businesses have costs. Investment funds get compensated in two ways: (1) they charge a management fee which is a percentage of the assets they have under management and (2) they receive a performance fee based on their investment returns. Therefore, by taking it to it’s extreme, if all fund managers allocate their resources in equal proportions to the stocks composing the market, 100% of them would underperform the market index net of fees.
So, when picking funds, just stick with the winners, right?
Not true. In 1990, a then relatively unknown asset manager called Howard Marks wrote a letter to his clients called “The Route to Performance“. What pricked him to write the letter was a statement that he read from the president of a prominent investment fund in the Wall Street Journal. The firm had had a difficult 12 months, which had caused it to lag the S&P 500 index, not only during the 12 month period but also over the last 5 years.
The reasoning that the President offered was that in order for the firm to be in the top 5% of the best performing funds, they had to be willing to be in the bottom 5% from time to time. Howard argued against this statement with an example of a pension fund in the Mid-West. Over a period of 14 years, the worst year of relative performance had put the fund in the 47th percentile of funds and the best year had delivered them to the 27th percentile.
Then came the shocker. This prolonged period of mediocre performance had delivered the fund to the 4% percentile of relative performance compared to other funds. Howard concludes:
Simply put, what the pension fund’s record tells me is that, in equities, if you can avoid losers (and losing years), the winners will take care of themselves. I believe most strongly that this holds true in my group’s opportunistic niches as well — that the best foundation for above-average long term performance is an absence of disasters.
So, you should be passive and invest in the index, right?
Stock market indexes have existed for a long time. The Dow Jones Index was launched in 1885, the Standard and Poor’s 500 was launched in 1957 and the Nasdaq Composite in 1971. The indexes had conventionally been used as a benchmark for performance for asset managers. However, in 1974, a man by the name of John Bogle, performed one of histories biggest act of Schumpeterian creative destruction when he launched the world’s first index mutual fund.
Inspired by the idea that the majority of mutual funds are not able to beat the index, Bogle created a mutual fund whose sole purpose was to mimic the S&P 500. As the management of the fund would neither require it to form any opinions, the fund would be able to cut costs significantly compared to the actively managed funds. In fact, to mimic the S&P performance, cutting costs would be a requisitive for the fund.
So, for those who want to invest their money in a safe way without having to think too much about it, investing in an index fund is the way to go. Equities of public companies, as an asset class, have historically rewarded investors with higher yields than debt securities. Economists call this the Equity Risk Premium. By investing in an index the passive investor gets rewarded in two distinct ways:
- lowers risk by diversifying his investment over the whole index, thus limiting exposure to any single equity
- achieves significant cost saving as index funds are much more cost-efficient (there are no analysts as the fund makes no decisions)
Since you’ve already made it this far into the piece, you’re already deep into finance geek territory. Hence, your appetite for thinking about investing must extends beyond the realms of mere passive investing.
Should I be interested in Active Investing?
The Fundamental Finance Playbook is for those who are not educated in finance but have a hunger get a deeper understanding of how to allocate their resources. The Playbook has two main sections:
- Mental Models: This section covers ideas and concepts that in one way or another relate to investing or finance in general.
- Histories: Here, you will find articles with stories and cases that in some way relate to specific mental models.
So, go ahead. Browse the shop. Kick some tires. Tell me what you think.