closet indexers overpay

A friend of mine was complaining recently about the price of apples, specifically a variety marketed as a “Honeycrisp” apple.

He would go to the grocery store to buy a bag of apples and find Honeycrisps at $7.99 a three-pound bag. Right next to them would be Gala apples at $3.99.

“Why are Honeycrisp apples so darned expensive?” he demanded to know.

He knows why. Honeycrisp apples are sweet but crunchy, a neat genetic trick developed by growers that creates its own demand. People love them and will pay more for them.

I don’t know much about the apple growing business of course, and supermarket pricing is a science these days. But it seems clear that the price is driven by demand for a superior product in limited supply. Gala apples are just fine, very crunchy, just not as sweet.

The problem in the investment world is that, increasingly, there are essentially no “Honeycrisp” investment managers. More than 90% of large-cap funds lag the S&P 500 Index over a 15-year period, according to S&P Indices research.

You might manage to pick the fund that is in that magical 10% of winners. But you won’t have won much for the effort, a marginal beat over the index, assuming the fees don’t eat the difference and more.

What’s more, chances are very high that a winning fund this year will be a loser the next, even close down completely.

Market researchers call this “survivorship bias.” Fund companies look better than they really are because they simply stop accounting for their losing managers.

Meanwhile, the massive surge toward index investing by millions of retirement savers has created a dynamic wherein fund managers have to admit, if only to themselves, that active management is not magic. Nor is it really worth paying for.

Faced with oblivion, managers under pressure soon become closet indexers. They charge a full rate for their alleged skills, but then they put their clients’ money into index products or, weirdly, they seek to quietly replicate the index outcome at a higher cost.

How much higher? Typically, much higher. The average expense ratio for an actively managed mutual fund is 0.75%, reports Morningstar. The average index fund costs 0.17%.

Nevertheless, the outcomes are not better for active management. Nobody has the secret sauce. We know from watching the continuing hedge fund debacle that being extraordinarily right once in a generation can make your rich.

Then, two things happen. That hedge fund star almost certainly spends the next decade or so giving back gains. The fund sees massive redemptions and is pressured into closing down.

Secret sauce

The other thing that happen is nobody seems to notice or care about the thousands of hedge fund investors who didn’t pick the big winner. They pay the outsize fees — 2% of assets and 20% of profits — yet get nothing like that crazy one-off payday.

The secret sauce, such as it is, is incredibly boring. Keep costs low, diversify, rebalance and contribute steadily to a portfolio of index funds.

If you pay any fees at all, make sure it’s for something you actually need, such as risk-adjusted portfolio construction. A financial advisor can be a solid choice, if you actually get advice.

What you shouldn’t pay for is above-market performance. The data shows it doesn’t exist, not even for rich people who theoretically can afford it. If you like a sweet apple, buy those Honeycrisps and enjoy them.

If you want to retire with more, recognize that it’s all Gala apples and make your peace with that fact. You’ll be far better off in the long run.

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