Why is active asset management typically not a good strategy for investors? Previously, we discussed a few factors. Sales commissions. Active management costs. Inability to time market movements. Efficient markets make it difficult to consistently pick the “best” investments.
But what does actual investor behaviour tell us about active investing? How are investors dealing with the active versus passive management debate? What lessons can you take away for your own portfolio?
All that and more in Episode 38 on the Wilson Wealth Management YouTube channel.
In Episode 36, we saw that the some research studies believe active management can beat passive. While other studies find the reverse. That passive management is the best approach.
In Episode 38, we take a look at what investors are doing. How their investing patterns are changing over time. That may provide some real world information that helps in your decision-making.
“If active managers cannot outperform, why do investors continue to pay sales commissions?”
Good question. If a specific investment fund, or other asset, cannot achieve alpha – outperformance of its passive index benchmark – why do investors readily pay a load (sales commission) just to buy the asset?
The reality is they are not.
In the past, a lack of investor education and strong investment company propaganda (marketing) led investors to believe they should pay for the privilege of owning a fund.
As well, the belief that the cost of purchasing was related to the “free” investment advice received.
We see in the data that investors are continuing to move into no-load funds. Is it just great marketing from no-load fund companies? Or perhaps investors are simply tired of paying for nothing.
“What does the data say about ongoing fund costs?”
We have discussed how Management Expense Ratios (MER) are a significant drag on fund performance.
What are typical levels of MERs in funds and fund asset classes?
As we have covered, we see that MERs indeed do tend to correlate to the specific asset class and the work required to manage the fund. The more simple markets tend to have relatively lower costs than the smaller, more complex markets. If you intend to invest in market niches and/or inefficient markets, as we considered in Episode 37, you may end up paying higher costs.
We also see a tightening off fees over time between funds. This makes sense as we have discussed how investment costs are a large predictor of fund success. Also, with increased competition for investor capital, funds need to compete on prices to a greater extent than they did 20 years ago. This is even more true, given that they cannot promote outperformance to potential investors.
“What about the MER differences between index and active management?”
Again, we see the data reflect the points previously discussed.
In 2019, MERs for actively managed equity and bond funds averaged 0.74% and 0.56% respectively.
In 2019, MERs for index equity and bond funds averaged 0.07%.
If a realistic return expectation is 6-8% per annum for a portfolio, the active managers need to do very well to compensate for the higher annual costs.
“What does the data say about market timing?”
It is hard to believe that professionals have difficulty timing market movements. A large part of the problem is that getting it wrong, even for just a few days, may greatly distort long-term returns.
For example, you invest $10,000 in the S&P 500 on January 1, 1980. If you took a buy and hold approach, on December 31, 2018 the portfolio was worth $659,515.
However, if you decided to market time, results may be different. Had you just missed out on the 5 best days of the entire 13,870, your portfolio would have fallen to $426,993. A 35% decrease.
If you missed the 30 best days, your portfolio would be worth $125,080. An 81% decrease.
And yes, perhaps if you had timed the declines, you may have been compensated. But it is very interesting how missing out on a few very good days over 18 years has such impact on growth.
Also, look back on the last 20 years or so. After the 9-11 crash. The 2008 financial crisis. The 2016 Trump election. The COVID bull run. Listening to the talking heads on television or assessing on your own, would you have reinvested exactly at the bottom, right as the market started upwards again?
Some good investment lessons to be found in this session. If you wish to read a little more on this topic, please refer to, “Why Active Investing is not Optimal”.
