Monday Morning: Active is better, but fees make it worse

I have written in this column in the past that on average, actively managed equity mutual funds don’t beat the stock market indexes.

Professor Martin J. Gruber of the Leonard N. Stern School of Business at New York University corrected me on that while speaking at a conference this month. That statement isn’t exactly correct.

Actively managed equity funds, on average, do beat the market by a small margin, but not enough to offset their management fees.

Mr. Gruber, with colleagues Edwin J. Elton and Christopher R. Blake, over several years have carried out a large amount of research on the performance of mutual funds. That research has produced good news and bad news about investing in such funds.

The good news: On average, actively managed equity mutual funds outperform the indexes by about 0.65 percentage points.

The bad news: On average, such funds charge management fees of 1.3 percentage points for that performance. As a result, after fees, they underperform the indexes by 0.65 percentage points.

A bad deal

That is, the funds’ portfolio managers are producing information worth 0.65 percentage points, but they are charging 1.3 percentage points for it. That’s a bad deal for investors.

The good news: Mr. Gruber, Mr. Elton and Mr. Blake found that funds performing well in a given year have a slight tendency to continue to perform well the following year. And funds that have performed really badly continue to perform really badly.

The bad news: The tendency to perform well after a good year usually lasts only for a year or so. If an investor holds the fund for three years, the excess performance falls to zero.

Many investors do move into the best-performing funds and out of the worst-performing funds. Cash flows into the best-performing funds increase an average of 29% the following year, while they drop 15.4% for the poorest-performers.

But it seems, on average, the investors don’t move quickly enough to capture the excess performance.

Some investors, the sophisticated ones, do look at past performance and expenses, and move quickly. But there are unsophisticated investors who don’t look, and there are others, such as 401(k) plan members, who are allowed to invest only in a small group of funds.

The latter two groups of investors underperform. One would expect those two groups to make significant use of index funds.

But Mr. Gruber also noted in his speech at a Stern-sponsored institutional investment management conference in New Orleans that while individuals have been net buyers of equity mutual funds, they have only 8% of their equity assets in index funds. Institutional investors have almost 50% of their investments in stock index funds, he said.

“Why is there this difference?” he asked, especially as there is now a large selection of index funds with fees ranging from just 0.19 percentage points to 1.35 percentage points.

After all, index funds offer most of the services active equity mutual funds offer: record keeping, the ability to move money among funds, daily valuation, low transaction costs and low-cost diversification. The only thing the index fund does not offer that actively managed funds do is professional security selection.

One reason for the limited use of index funds is that investors believe there are superior managers, and they believe they can identify them. As noted above, they are right on the first count, but the jury is still out on the second.

Role for advisers

It may be difficult for the average investor to pay sufficient attention to capture the excess returns produced by the well-managed mutual funds by shifting quickly into the top-performing funds and then moving out after a year or so.

But financial advisers certainly should have the time and interest to follow such a strategy for their clients. Of course, if every adviser did that, the excess return might be arbitraged away.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.