Why Do Investors Keep Buying “Actively” Managed Funds?

Important question here by Larry Swedroe from last week.  If we know that active managers are very bad at trying to beat the market then why do investors keep giving them assets?  This is no small topic, but I’ll try to summarize my views here.

Before we begin, we are all “active” investors to some degree.  No one, not a single one of us, can implement a truly passive index strategy in the same way that is so often cited by many studies against “active investment management”.  We buy and sell periodically, we rebalance, we change allocations, etc.  So, let’s all get on the same page and agree that we are all active investors to SOME degree.

Now that we’re all on the same page there the question changes a little bit.  If we know that more active managers are not very good at generating high risk adjusted returns or beating the market then why do investors keep buying their funds over a less active and low cost index fund style approach?   I have a few thoughts here:

  1. We are all pretty stupid when it comes to money and finance.  In fact, the SEC found that “U.S. retail investors lack basic financial literacy”.    So, as Larry notes, financial literacy is a huge problem.  In fact, if you’re reading this website I’d be willing to bet you’re WAY ahead of the game to begin with.
  2. We are extremely biased and emotional animals.   Not only will we convince ourselves of things that are totally false in an attempt to make money and protect it, but we react inefficiently at almost every twist and turn in dealing with money.  As Laurie Santos shows, we’re about as good with our money as apes are because we’re just not designed mentally or emotionally to handle such a fragile construct.
  3. We are told on a daily basis that we must “beat the market”.  And we’re told that if we don’t “beat the market” then we’re losers or average.  But the funny thing is that the market is the market in the aggregate.  And in the aggregate NO ONE beats the market.
  4. We confuse real investing with allocation of savings.  We are told on a daily basis that we are “investors” on secondary markets who can strike it rich if we just buy the right stocks and bonds.  But the reality is that when you buy stocks or bonds on a secondary market you are allocating your savings into what was really someone else’s “investment” and it’s very likely that the easy money has already been made and these real “investors” are cashing out.  Real investors build future production, make great products, provide superior services and only sell their majority interest in that production at a much later date (often on a stock exchange via an IPO).  The idea of getting rich in the stock market puts the cart before the horse.  You shouldn’t look to “get rich” in the stock market.  You should look to get rich making investments in yourself and on primary markets where real investment is done.  (See here for more).
  5. We don’t account for real, real returns properly.  In other words, we tend to hear about the nominal return of the stock market or something like that and fail to account for taxes, fees, inflation and other frictions.  And in doing so we fail to account for how much a high fee or other frictions can really diminish our returns.  (See here for more).
  6. We don’t benchmark fund managers appropriately so we end up comparing managers in ways that really make no sense.  Most of us will look at nominal returns and declare a fund to be worthless or a good buy.  Not only are we datamining and falling victim to recency bias, but we’re not looking at risk adjusted returns.  And so we see ridiculous headlines about how “hedge funds underperformed” even though the comparison is likely an apples to oranges comparison of underlying fund styles.   (See here for more).

All of this leads us to buy into a dream of a road to riches in the stock market that often turns out to be a nightmare.  Don’t get me wrong.  We’re all active managers of our own accounts and there are ways we can manage our assets efficiently so that we reduce frictions, taxes, fees and optimize returns to meet our personal financial goals.   And there are actually active money managers out there who charge very reasonable fees and provide strategies and services that are very useful for clients in numerous ways.  Unfortunately, most “active” fund managers are closet indexers or doing something that adds very little real value to a portfolio while charging 1%, 2% or even more.  But when you consider how poorly most of us understand these topics, well, it’s pretty enticing to fall for the idea that a smart guy working on Wall Street can help you “get rich” in the market….

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  • FXTrader

    Great summary. What would be your criteria for buying what is traditionally thought of as an “active manager”?

  • activeanon

    I’m an active manager. Most days I feel kinda bad about that.

    The job itself is interesting and challenging but I don’t know that my work ultimately adds value. I’d like to think that professional investors play an important role by evaluating businesses and management teams on a company by company basis. But we have long since squandered the reputation that would lend us any legitimacy in that role.

    Maybe whatever role us active managers play as “shepherds” of capital can be replicated by the governance departments of large index fund providers.

  • http://orcamgroup.com Cullen Roche

    A good active manager can add real value if they:

    1) Profile clients properly, help them understand risk and apply the right mix of assets to their profile.
    2) Help and maintain portfolios for clients in a way that reduces frictions, fees and taxes.
    3) Help clients maintain a portfolio and process that protects them from their inherent biases and gives them confidence that someone with integrity and understanding is keeping an eye on their assets as time goes on. Ie, allows the client to confidently focus on OTHER things in life without worrying about trying to manage assets on their own.
    4) Generate high risk adjusted returns for clients by giving them access to alternative strategies and assets that might not be otherwise available through an index fund.

    I think the passive index fund community’s attacks on “active” managers are often unfounded or misleading. That doesn’t mean most active managers are earning their fees or adding value, but the blanket rejection of some forms of active management are wrong in my view.

  • Alexis Smith

    I couldn’t agree with you more, Cullen. You make a great point. I learned a lot through this article, as well as the other articles you posted. Thank you for sharing your knowledge.

  • BAlex

    Passive investment strategies, however they are defined, are no better than any other strategy unless they are adhered to during times of duress. As I have mentioned before, I suspect the actual numbers of investors who claim to be passive and actually stay passive at market extremes is much smaller than the advocates claim. I applaud Cullen for pulling the curtain back on the deception and marketed claims about the purity of passive investing. There is nothing new though as bull markets always bring out the passive flag wavers.

  • BAlex

    I agree. The argument between passive and active is always made at the extremes. There is plenty of middle ground between the DIY retired Bogglehead and the bloated old-school mutual fund charging 1.25% and lagging the market.

  • http://www.basonasset.com James Osborne

    Hey Cullen,

    This is probably just semantics, but I’d argue that points 1-3 are really the role of a good advisor and are much more difficult to execute if you’re a traditional asset manager (say a PM at a fund company). I’m less convinced about point #4 being done by anyone but you already knew that.

    I think Anon’s point is very interesting – the cognitive dissonance that most money managers must go through would be gut wrenching. It would be very difficult to go to work each day if you truly believed you weren’t adding any value – I know that I felt that way a few years back in a traditional “manager of managers” role. I have always wondered if PMs truly believed they were capable of outperformance through stock picking or they realized how fruitless their pursuits were but kept on because we all have bills to pay.
    – James

  • http://orcamgroup.com Cullen Roche

    Hi James.

    Yes, I totally agree. In many cases the PM is outsourced. So the role of the advisor really becomes managing the managers. I personally prefer not to execute through many higher fee active managers so I don’t see this as a big problem personally, but I think the vast majority of advisors are still using what we would call “active managers” through vehicles like mutual funds or higher fee ETFs (“smart beta” and junk like that) as opposed to true index funds.

    #4 is something I run across fairly often actually. For instance, when I audit hedge funds I very often run across a manager who is accessing private markets or non-publicly accessible markets where they are adding value to the portfolio through strategic diversification. These types of strategies aren’t accessible through most ETFs or a truly passive index so every once in a while I do run into funds that I am comfortable with because I think the manager is really doing something that’s valuable. Of course, it depends on lots of other factors (such as fees, strategy, transparency, etc).

    A more traditional and common form of “active management” is business hedging via things like FX exposure and commodity price exposure. This is truly where the concept of hedging can play a hugely important role in helping a business operate. It’s what we would call “active management” or even “trading”, but it’s often a very useful form of adding value through a more active approach. Passive management adherents often overlook these contributions to a portfolio and instead build strawman arguments about closet indexers or day traders and how none of them “beat the market” for sustained periods. Of course they don’t. Those approaches are the ultimate losers game.

    I started in this business selling insurance that no one needed and pretending to be a 23 year stock expert after reading a morning report. Trust me, I know the feeling. It made me sick to my stomach and eventually threw in the towel on that when I saw an out…. :-)

    Have a good weekend!

  • jaymaster

    Or to go REALLY old school: Lust, greed, sloth, envy, pride.

  • Midas II

    I read that the government is trying to get brokers to put their clients interests ahead of their own, and facing strong resistance.

  • Normand

    All excellent points but I would disagree somewhat on #4.

    You write « But the reality is that when you buy stocks or bonds on a secondary market you are allocating your savings into what was really someone else’s “investment” and it’s very likely that the easy money has already been made and these real “investors” are cashing out. »

    To me it sounds like saying

    “Don’t buy a used home, the project builder has already made its easy profit.”

  • J Thomas

    To me it sounds like saying

    “Don’t buy a used home, the project builder has already made its easy profit.”

    A used home might be a good deal for you and may be the best deal you can afford.

    But it’s useful for some purposes to notice the difference — when you commission a new home, you contribute to GDP. Everybody who makes new stuff is getting paid to make something. When you buy a used home, mostly it doesn’t increase GDP at all. Something that was already made is changing hands. Maybe 10% or so closing costs contributes to GDP, the realtor’s cut, all the people who do their productive work inspecting and reporting and licensing so you can legally take title, all that is GDP, but the house itself is already built.

    You might preserve your wealth or even increase it buying existing stocks on the stock market, AND that has essentially nothing to do with growing the economy. You are only exchanging rights to profits, and what you do has nothing at all to do with creating those profits.

  • J Thomas

    Oops.

  • Alberto

    “You might preserve your wealth or even increase it buying existing stocks on the stock market, AND that has essentially nothing to do with growing the economy. You are only exchanging rights to profits, and what you do has nothing at all to do with creating those profits.”

    This means that ONLY someone will be able to cash the profits while someone else will record a net loss. The financial system is a closed system, it can’t create more net wealth than the real economy. In the short time is looks like it can, but on the long term it’s not possibile. At a certain point you have to cash out to buy real stuff and so the final score will be AT THAT POINT. All what happend before has no importance.

  • J Thomas

    This means that ONLY someone will be able to cash the profits while someone else will record a net loss.

    If a company looks good, and I buy stock, maybe the guy I’m buying it from has a nice profit in it and then I can get a nice profit too. It isn’t inevitable that anybody will have a net loss. But that does seem to happen a lot.

    The financial system is a closed system, it can’t create more net wealth than the real economy.

    True, but while the real economy is creating wealth it can benefit from that wealth. Dividends and stock buybacks transfer wealth from businesses to stockholders. Then the stockholders (or former stockholders) can spend the money, or else use it to buy stock from each other at higher prices.

    At a certain point you have to cash out to buy real stuff and so the final score will be AT THAT POINT.

    But if somebody else is buying stock while you sell it to spend the money, there isn’t a final score at that point. The cycle still continues. Ideally you would like to sell when lots of people are buying, and then buy when lots of people are selling. Like, if a lot of people needed to sell in September to pay for their kids’ college, or in April to balance their portfolios for tax reasons, that would be useful. But unfortunately previous speculators seem to have pretty much already balanced that stuff out.

    All what happend before has no importance.

    For yourself, you have to pay tax each year on the stocks you bought and sold even if you haven’t taken any spending money out, unless you have special promises on record that you won’t take the money out any time soon. That has some importance. But yes, you only have paper profits until you actually take the money out and spend it.

    For the system as a whole, it makes a great big difference when more people pull money out than put it in, or vice versa. Because people value their stocks based on the current price, so a few sales at one price sets the official value for ALL of the stock. People think that’s important even though they can’t actually buy or sell great big blocks of stock without having a big effect on the price.

    So when money leaves the market and prices generally go down, lots of people feel poor. That can have a big effect on the economy. When they panic and sell at a loss, driving the price down farther, they may feel *very* poor. Since some of the people who play the market are business managers, when they feel poor they may expect that demand will be down so they fire people and cut production, and then sure enough demand will be down.

    In better times those guys get a significant part of their income from stock options, so they have an incentive to spend their efforts managing the news so their companies’ stock prices are high when their options come due. Would the economy be better off if they spent their time actually managing their businesses for the long term? I don’t know, nobody knows. If businesses do better when their managers concentrate on running the business it would be true but maybe they are on average worse than useless.

    Imagine that the rules of the game were different, so that people have an incentive to look at the long-term prospects of the companies they buy. They would look at the financial statements, and try to connect them to the realities of what the business does, and guess how well it will do in the future. They would not care so much about short-run changes in stock price. Since they didn’t care about that, volume would be way down and prices would be much more stable, both. That might be good for investors, but it would be bad for stockbrokers. And the rules of the game are made by the brokers, for the benefit of brokers.

  • Alberto

    a lot of words that don’t say nothing because clearly you don’t understand the nature of the exponential function like 99,9% of mankind. Start from here:

    http://www.albartlett.org/

  • J Thomas

    Alberto, you have a clear understanding of a lot of important things. I didn’t get my point across this time, so I want to try again.

    You pointed out that the stock market is secondary. It is like a casino, where people go to gamble. The real economy adds to the winnings so it is not exactly a zero-sum game like other casinos. In a regular casino anything you win somebody else has to lose, but when companies pump money into the game people can win more. Except in the long run the companies can’t keep adding more wealth to the casino any faster than the growth in GDP. They can grow faster than GDP by sucking resources away from somebody else, like labor, but that’s a one-time thing — they can’t keep doing that at an ever-increasing rate because after awhile it’s all gone.

    So the secondary markets are in fact secondary, and they do not directly affect the economy, but the economy directly affects them.

    I think this is the basic point you were making. And you implied the second point for individuals that you only get real benefits from the casino when you walk out of it with money. While you increase the amount that you play, you can have paper profits. When you have put a million dollars into the game and you are two million dollars ahead, you might feel like you are doing very well. But if it is all at risk, there is no guarantee that you can successfully get it out of the casino. Possibly the high price of your possessions will only stay high while you are buying, and it might drop fast when you try to sell. This relates to Cullen’s point that you should keep some of your money out of the market where it will be safer.

    What I’m saying is that the crazy secondary stock market does have a variety of second-order effects on the real economy. In general I think these are bad effects but I don’t get to choose.

    The stock market affects actual corporate decisions in a variety of tail-wags-dog ways. If you believed in efficient markets and an efficient invisible hand, it would take a lot of pretzelly logic to justify why this results in a better economy. I don’t believe it results in a better economy.

    The stock market is arranged this way because it was created by brokers and for brokers. The more they could get people to buy and sell, the more churn there was, the more easy risk-free commissions they got. It was good for brokers and bad for the economy.

    Now with the technological changes which allow vastly increased trades and also low commissions, the system has changed in ways that probably nobody understands. Brokers probably thought they would be better off this way, but they might have been wrong. Maybe nobody is better off.

    It is not clear to me that anybody is in a position to make good reforms or get new competing markets going. There was some effort to create NASDAQ as a good system. The people who designed the stock market in India made a serious, public, conscious effort to get good results for investor/gamblers. I haven’t seen a study measuring how well they did.