Ship of Fools

Every time I think enough has been said on the folly of active management, the universe reaches out to me.

This time in the form of my girlfriend’s 401k plan options: for every sensible, low-cost index fund option, there were also three or four expensive, actively-managed funds in the same space. This leaves everyday investors with an investment minefield they will likely not have the expertise to navigate, and me with a slightly higher blood pressure.

Index funds have been gaining market share in recent years, but the majority of investment funds are still actively managed, even though study after study continue to show that the vast majority of active managers are likely to underperform their benchmarks!

To calm down from this offense against rational thinking, I decided to throw on one of my favorite songs by the Grateful Dead: Ship of Fools.

That’s when it hit me. Active management, and the whole industry built around it that makes fund managers rich selling promises to investors they usually fail to deliver, is just a great big Ship of Fools!

So as Jerry Garcia said in the song that inspired the title of this blog post “I will slave, to learn a way, to sink your Ship of Fools!”

Okay, maybe sinking the whole ship is a bit of a lofty goal for one financial advisor. But I can at least get a few more people to jump off before it’s too late! Time to blow up active management both philosophically, and empirically, once again.

What is Active Management?

Active management is based on the idea that you have to play the hectic game of owning the right things (pick stocks) at the right time (time the market) to be successful as an investor.

Active fund managers will do tons of research, employ entire departments of people to procure the best information, all to make forecasts and decisions on individual companies and asset classes. As you may imagine, all of this activity creates a lot of extra expense that must be paid by investors in the fund. But does it make investors better off?

The important question is: better off compared to what? And the most logical comparison is what an investor could have received by passively investing in that same type of investment, or asset class. The financial industry uses “benchmarks” – a broad market index of certain types of investments created to represent an asset class and the return an investor could have received simply by investing in that asset class. These benchmarks provide a relevant performance comparison to see if active managers actually created value with their actions.

The million dollar question then becomes, can active managers beat their benchmarks?

The chart below, compliments of Dimensional Fund Advisors, sums up what the data says.

As you can see, the vast majority of active managers who set out to beat a benchmark fail to do so, and a lot of the funds do so poorly they don’t even “survive” – they are closed down or rolled into other funds.

There are a few common sense reasons why.

It’s Tough to Be Smarter than the Market

Markets do a very good job of incorporating all information and expectations from participants instantly.

The debate about whether markets are efficient is inescapably linked to the debate about whether or not you can beat them. I think the video below does a great job of explaining why they are.

But this also brings up an interesting philosophical loop from active managers – as any attempt to outguess the market assumes the market price will eventually converge to the “correct price” at some point in order for you to be able to profit from your knowledge. In order for active management to work, markets have to get smart and recognize you are right eventually.

So active managers as a whole are operating on the strange assumption that the market is wrong now, but for some reason it won’t be in the future.

You can know the true “correct price” of a stock – but if the market never recognizes and you have no way to benefit from that information – you can go to your grave knowing the “correct price” of the stock, feeling very confident in your knowledge, but no better off financially because of it!

Costs and the “Arithmetic of Active Management”

As we mentioned before, employing entire departments of people and procuring all this “special” information on which to make stock picks and forecasts costs money, a cost that is ultimately passed on to the owners of investment funds.

Though fees on investment funds have come down in the aggregate over the years as investors have become more fee conscious, it is still common to see investment fees approaching 1% for funds covering asset classes that could be delivered for 1/10^th or 1/20^th the cost.

Which brings us to our next argument, part philosophical, part mathematical – The Arithmetic of Active Management – first proposed by Nobel Prize winner William Sharpe.

All investors, active and passive, make up the whole of the market. So if one active manager buys and “overweights” a stock or sector, another active manager must have been on the other end of that trade and underweighted that same stock or sector.

These transactions do not create value – they are shifts from one pocket to another. So active managers as a whole, in spite of all their buying and selling, must receive the total return of the market.

But there was one catch – both the active managers in the example paid to play the game! So the return you would expect as a whole from active managers is therefore the market return, minus their costs – a large hurdle rate that active investors must overcome. If the average expense ratio of all actively managed funds out there was about .7%, I’d expect active managers as a group would underperform the market by about that much.

I realize sometimes abstract philosophy is harder to relate to than concrete data. Fortunately, the data tells the same story:

The higher the cost, the less likely the fund was to beat its benchmark. Large expense ratios are simply too great of a hurdle rate to get over to actually create value for investors.

Can I pick the winners?

I know what you are thinking – some people do beat the market. The problem is, it is impossible to know who these people are in advance.

The place people most often look for future winners is among those that have performed well in the past, but is this a sensible idea?

As the chart above makes clear, even if you pick from the past winners you are still likely to be disappointed the vast majority of the time going forward. There is a reason every investment fund statement must clearly state “past performance is not an indication of future results.”

“It was later than I thought, when I first believed you”

You’d think all the data we’ve just reviewed would be compelling enough to keep people from attempting to “beat the market” themselves or paying extra for professional money managers to try to do it for them. The unfortunate reality is that most people don’t recognize the dangers of active management until after it has blown up in their face.

Maybe they invested a significant portion of their portfolio in one stock and it became worthless. They got caught up in Bitcoin at exactly the wrong time. Their market timing scheme caused them to miss out on a stock market rally. The list is endless.

These are usually mistakes people recognize and learn lessons from.

But much more likely than that is the possibility of a fund manager missing out on the return of an asset class that was easily there for the taking - for example, when an actively managed large cap growth fund only returns 10% over a time period when a simple S&P 500 Index (the same asset class) went up 20%. You may not even notice the damage without really watching the numbers, but missing out on a 10% return is “losing” 10% of your portfolio’s value any way you slice it.

I find the most passionate believers in passive management are reformed active investors who recognized the folly of their ways only after it was too late. I wish it didn’t have to be this way.

Final Thoughts: “Though I could not caution all, I still might warn a few”

As a financial advisor, it is my job to help people avoid mistakes that could have a material impact on their ability to achieve their financial goals. There are plenty of ways active management can go wrong that outweigh the slim chance of it working out and make it a fool’s errand.

Though it may not be as exciting as attempts to “beat the market,” investing in low-cost, passively-managed investments is simply a more reliable way to achieve the goals that are most important to our clients who trust us with their retirement lifestyles.

The active management “Ship of Fools” is so large it is not going to be sunk, or even redirected, by the efforts of humble financial bloggers or advisors anytime soon. But people can jump off before it’s too late, and every additional person spared the pain of active management blowing up in their face and costing them their financial goals is, to me, a victory.

By Paul R. Ruedi, CFP®