Broker Check

‘Scale and Skill’: Why It’s Hard for Managed Investments to

| May 11, 2014

“The battle between actively managed mutual investments and their index-style competitors is like a decades-long sports rivalry.” 


Detailed recent readers know my professional opinion on this issue.  Candidly, I feel that both the research and historical results are clear – the very great majority of us – clients and advisors alike – are better off with indexing.


At one level, I’m not sure that the “why” is all that important.  The obvious reason is (internal) fees and / or expenses.  Many index investments could have an internal expense of 0.2% or less.  While active or managed investments might easily have internal expenses of 1.2% or more.  That one percent may not sound like much, but it adds up over time.


Thought of another way, if the S & P Index returns 10.2% and the internal charge is 0.2%, then the index investor receives (approximately) 10%.  For a managed or active investment to net the same 10%, that investment must achieve an 11% return – less the 1% fee equals the same 10%.  The managed investment must “outperform” the index by approximately 10% in this example.


But wait a minute.  What if the S & P returns 5.2%.  The indexer nets 5%.  For the managed investment to perform comparably, it must achieve 6.0% return – less the 1.0% fee equals the same 5.0%.  But that is an outperformance of 20%!  [6 divided by 5 = 1.2 . .. -1.0 = .2 or 20%)


Maintaining that kind of consistent performance is a very difficult hill to climb, so to speak.


The article referenced below also provides some informed speculation that the large growth in the managed or active investment industry has also increased the difficulty of the active folks outperforming the indexers.  The authors can’t necessarily prove it, but they make an interesting case.


My professional opinion is that investing is (mostly) not about belief.  But I actually do believe that somewhere out there, there are a relatively small number of professional investment managers who actually do have the ability to consistently outperform the indexes – net of fees . .  and not just due to luck.  (Also just my opinion – Seth Klarman might be one of those people, for example.)


But my opinion and observation about Klarman and possibly others is not that relevant – at least not to the “average” investor.  The average person who is retiring and rolling over her / his 401-k / 403-b / TSP etc. does not and likely will never have access to the Klarmans of the world.


Also, to the extent that the Klarmans are consistently beating the indexes, they are going to tell as few people about it as possible!  Because if it becomes widely known, there will be attempts to “reverse-engineer” what these winners are doing.  Then, when too many people start doing it, their advantage disappears.


So, if you are a middle-class retiree – or soon to be, consider sticking to index investments!


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