John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.
Warren Buffett, the billionaire famous for selecting stocks that become winning investments, has long said investors would be better off ditching high-fee actively managed funds and putting their money in low-cost indexing strategies.
That is because active managers often go through droughts during which they lag the market. Mr. Buffett wrote about this in his recent annual shareholder letter, repeating advice he gave shareholders in 2005, when he said professional investors – over a period of years – will underperform the returns achieved by amateurs doing nothing more than putting their money in an index fund.
Fees are a big reason for this. Though fees for actively managed funds have been on the decline in recent years, as of Morningstar's report in 2015, they were still around 0.7 per cent of annual assets under management, compared with 0.2 per cent or less for passive funds.
Fees, combined with a streak of bad luck, weigh on returns. Just think about it – you hire an active manager and pay them a 1-per-cent to 2-per-cent management fee and then a strategy stumbles, trips and underperforms for a year, two or even longer. It's incredibly difficult for most investors to have the patience to stay with a strategy, and pay fees, when it's not working. Guess what? Most will bail.
By Mr. Buffett's reckoning, investors have lost out on $100-billion (U.S.) in fees and underperformance over the years. People have taken heed, rebelling against active managers. Last year, investors poured $505-billion into passive strategies, while some $340-billion was redeemed from active managers, according to Morningstar.
The trend is upending the asset-management industry. BlackRock has shifted away from its actively managed equity strategies to pour resources and attention into strategies that have elements of lower-fee, passive management.
Last year, S&P Dow Jones Indices did a study that found about 90 per cent of active stock managers failed to beat their benchmarks over the prior one-, five- and 10-year periods. When you read statistics like that, it's hard to make the case for active managers.
But it's worth noting that successfully replacing those high-cost funds with a cheap index fund depends on being disciplined as well. Many investors seem to forget that between 1999 and 2009, the S&P 500 effectively went nowhere. That was one of the worst decades for stocks ever, but the point is that indexing can go through long periods of very low returns and by indexing you will be 100 per cent invested during the markets advances and also the big declines.
Indexing was developed as a way for investors to try and match the market's return as closely as possible. That way, they could get the diversification they needed without spending the time and risk finding the right active manager.
That is part of the reason why Mr. Buffett says investors should stick with index funds.
All this is not to say that individuals can't find good active managers – because they are out there – but given that many investors look at the past three or five years of performance and make investment decisions based on trailing returns, it's one of the big reasons they struggle over time.
Identifying managers who are lucky from those who are skillful is more than an art than a science. Vanguard, one of largest fund managers on the planet, has a team of dozens of CFAs combing the active landscape consistently seeking out those managers who have the potential to outperform.
These analysts conduct due diligence, interview managers, evaluate the investment process and score firms based on multiple criteria. It takes a lot of time, effort and lots of expertise.
If you are the type of investor that values some degree of active management, there are a number of questions you should first ask (and before you look at performance), and you'll have to look to the prospectus and manager's website to get some of the answers.
For instance, do you understand the investment process and does it make sense to you? Is the manager exploiting some type of market inefficiency? What is the manager's long (at least 15-year) track record, if they have one? Is the investment and decision process consistent, repeatable and can the manager explain why he or she bought or sold a stock? Has the manager gone through periods of underperformance and what types of environments have those been in? Do you, as the investor, have the long-term commitment to the strategy (I would say at least five to seven years)? What are the fees and are they reasonable?
One of the gurus I follow, James O'Shaughnessy, said it best when it comes to active versus passive investing. Emotions are the biggest hindrance to investor returns over time, and he said that followers of index funds face a single – albeit big – point of failure, which is that many will panic and sell when the market falls. Active investors, according to Mr. O'Shaughnessy, face two, because they will also likely sell when the manager is underperforming the market in general. Those two points of failure will be more than most people can take.
So, if you think you can do the research to select a good fund manager and have the discipline to stay the course no matter what, active management might be a good fit for you. But if you can't, you are probably better off in index funds – just like Mr. Buffett would advise you to be.