Whilst in the 1970s investors were happy to hand their money over to a professional fund manager who could deliver returns in excess of the market, they would probably think twice before doing so today. As widely advertised in the press, fund managers have been struggling to beat the market, and investing in the S&P 500 index is, most of the time, a better choice than handing the money to a mutual fund manager, for example.
As reported by Bloomberg just recently, over the last 3 years, 4 out of 5 US mutual funds failed to beat the market. That is a shocking number. This means that through investing in a mutual fund you are in fact getting a lower return for your money and for a higher cost, as mutual funds will generally charge you a higher fee than index trackers. With this in mind, and given the huge selection of index funds and ETFs, which can be traded for very low fees, why would an investor continue to invest in mutual funds?
One big reason would be to better protect against downside. Investors could be willing to give up some upside to get protection against downside risks, as with the latest market crash of 2007-09. But that kind of protection is not offered by actively managed funds, which took a huge hit during the latest crash and subsequent crisis.
There are in fact now more than 7,500 mutual funds in the US, and which is 14x more than in 1979. This proliferation has led to a huge increase in competition between funds which, according to a recent academic study conducted by professors from the University of Chicago’s Booth School of Business and the University of Pennsylvania’s Wharton School, resulted in a drop in average performance. At the same time, information now flows very quickly. While in 1979 analysts took a material amount of time to analyse company statements and the flow of information, they now do the same in hours, if not minutes. Computers allow for the processing of large amounts of information in just a few seconds and information is widely accessible to everyone at the same time. The average investor now has access to historical data, company statements and information in real time and mostly for free. That was certainly not the case in 1979, when information flowed very slowly and asymmetrically, thereby making professional managers more valuable.
In a study conducted by Rick Ferri and Alex Benke for the 2013 SPIVA awards, at which they were awarded first prize, the researchers evaluated the performance of mutual funds and index funds in order to understand how active and passive fund managing compare in terms of performance. The results are shocking for professional managers, as they show that it is clearly better to invest in index funds (or ETFs) than in professionally managed mutual funds. They also show that the advantage is magnified in the long run, where they demonstrate a probability of 83.4% of index fund outperformance versus mutual funds.
Because diversification may be a concern, they also tested for a scenario under which an investor populates a portfolio with 3, 5 and 10 different index funds. The probability of outperformance for these portfolios versus mutual funds for 2003-2012 was between 87.7% and 90%, which clearly shows that an investor can not only achieve better returns but also a high degree of diversification by investing in a number of passive instruments.
These results are challenging for the fund management industry, which will face a tough time in the years ahead. The pressure on fund managers is now so high that it constrains personal initiative and fosters “group think”. Fund managers herd together, buying when the market is already overbought, out of fear of losing some upside potential. The flipside to this is that when crashes occur they are all set for huge losses.