Actively-managed mutual funds have professional money managers who can do a better job of investing than the rest of us, right? That’s not what the evidence says. Studies show that the average professional money manager does not get better results than the market averages.
There are a number of reasons for this including the difficulty of investing very large sums of money and the pressure to show decent results every quarter or face having investors leave the mutual fund. The simplest reason, though, is that professional money managers control so much of the total money invested in stocks and bonds that they dominate the averages.
The US Federal Reserve’s December 2007 statistics contain a breakdown of stock holdings in Table L.213. It is not immediately obvious which line items correspond to professional money managers, but if we include just state and local governments and their pension plans, insurance companies, private pension funds, mutual funds, closed-end funds, and exchange traded funds, we find that they hold 59% of all US stocks. Expecting the majority of professional money managers to outperform the average is a bit like expecting the majority of people to be taller than average. It just doesn’t make sense.
Once we take into account the fact that actively-managed mutual funds have much higher costs (loads and the yearly MER) than index funds, we find that index funds beat most actively-managed funds. Many detailed studies confirm this, and I’ll point to two of them. One study by Savant Capital Management found that for the years 1995-2004, actively-managed mutual funds lagged their indexes in all nine of Morningstar’s mutual fund style boxes. On pages 260-263 of the book “A Random Walk Down Wall Street,” Burton Malkiel showed that mutual fund returns lagged the S&P 500 index most of the time from 1972-1998.
Stay tuned for part 2 of this discussion.
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