It’s a question you hear over and over in the investment business: Why buy low-cost index funds when there are active managers out there beating the market silly?
And there are, absolutely, some managers and funds that have long and amazing track records. Warren Buffett is the obvious example, but there are also funds with no discernible “star” managers who absolutely outperform the overall market.
There are, too, managers of pension funds and college endowments that can point at 10 or more years of excellent returns.
Why not you? No reason. You could invest that way, but there are a few obstacles to overcome first.
Right out of the gate, remember the adage found on every prospectus: “Past performance does not guarantee future results.”
That’s a bit of legalese, of course, but it’s there to protect them, not you. If you buy a hot fund and over the next five to 10 years it does horribly, you might feel like suing somebody.
The “past performance” disclaimer gets the manager off the hook. More to the point, every manager worth his salt knows that a good one- or two-year run will draw in new investors.
He also knows that those new investors are very likely to experience what all popular investment strategies experience over time — reversion to the mean.
Either conditions change, or too many investors copy that strategy, or the economy suddenly turns tail. Whatever the reason, a few years of winning often is following by a few years of relative losing.
Second, you have to actually get into the fund to invest. Many good funds are closed. Sure, they’d like to take on more investor money, and to charge additional fees on that money, but often they can’t.
That’s because once a fund gets big enough it runs out of room to invest. Buffett himself often laments that there are no deals big enough for him to take part. He has too much cash.
Even smaller managers can find that having too much to invest reduces performance. Move a lot of money into the market at once and suddenly you are the market, the only buyer. Worse, you assume the larger share of the risks.
The biggest investment risk
Why buy index funds when active managers beat the market? Because, finally, that is the biggest risk of them all — guessing wrong.
There’s just no way to pick a set of money managers based on what you think is skill. Truth be told, many fund managers are closet indexers. Most struggle to justify their fees and turn in year after year of returns that, net of costs, fall short.
Do you think you can identify the small fraction of true star stock-pickers? Presumably, someone out there is so connected, so tuned in to the flow of talent to Wall Street that they can do this.
Most people can’t, and shouldn’t. Most people greatly improve their results just by lowering costs using index funds and avoiding the active mutual fund business entirely.
That way you get a predictable return from stocks that does, in fact, make a difference to your ability to retire with more, while avoiding the real risk of guessing wrong and paying high fees for the privilege.