Financial Reference

Actively managed mutual funds are one of the most popular investments for individual investors. They give individual investors access to diversification and professional management. So they should be a good investment for most people, right? Actually, it’s quite the opposite.

Actively managed mutual funds are not as good as other investments (including, most notably, index funds and ETFs) because there are many unchecked conflicts of interest between the manager and the shareholders of the funds. This can be seen in the performance of active mutual funds — which consistently underperform index funds (up to 4.5% after tax according to one study cited in the article cited below).

The objective of a mutual fund manager is to maximize the value of their management contract — i.e. increase the assets under management and increase expenses. These are the exact opposite of what the shareholders want.

The bigger the fund, the lower the probability that the manager will be able to outperform the market. There are only so many good investment ideas a manager can have, and the more assets, the more the manager’s mediocre ideas are going to creep into the portfolio. Warren Buffet once opined that since people only have a few good ideas, investors should invest like they can only invest in 20 companies over their entire lifetime. The more diversified, the more the portfolio will start to perform like an index — but don’t worry, you’ll still be paying the fees like it’s actively managed.

In addition to the hefty expense ratio you’ll be paying, some managements have the gall to charge you for selling more of their product, by charging 12b-1 fees. They claim it’s for your benefit since the more assets, the lower they can make the expense ratio. However, most funds have not reduced expenses when they get more assets. So they charge you extra to make the fund more like an index but don’t pass on the benefit of lower expenses.

Another source of conflict people often overlook is that managers try to maximize before tax return and so turn over their portfolios more than shareholders would like. If you are holding the fund in a tax-free account, this wouldn’t matter, but for the rest of us, this is another reason to favor index funds and ETFs.

It just doesn’t make sense to expect superior performance from an actively managed mutual fund. It’s hard to outperform (especially on an after-tax basis) when you have a diversified portfolio with high fees and high turnover. So, if you do choose to go with an actively managed mutual fund, prefer funds with low turnover, low fees, and a concentrated portfolio. If you favor these funds, you will have a better chance of beating the market. Of course, you would probably be much better off buying an index fund or ETF.

(For a great interview on this issue — and for the source of much of this blog — check out WSJ.com “Yale Manager Blasts Industry” (Sept. 6, 2005) — sorry, I don’t have a link.)