Posted By 
By Robin Powell, The Evidence-Based Investor*
Special to Financial Independence Hub
* Republished from the Just Word Blog from Robin Powell, the U.K.-based editor of The Evidence-Based investor and consultant to investors, planners & advisors
There are broadly two types of investing: active and passive investing. Active investors try to beat the market by trading the right securities at the right times. Passive investors simply try to capture the market return, cheaply and efficiently. So which approach is better?
Instinctively, most people who haven’t looked into the issue in any detail tend to assume that active investing is superior. After all, the thinking goes, it’s surely preferable to be doing something to improve your investment performance, instead of just accepting whatever return the market offers. Active investing has certainly been much more popular than passive in the past.
But if you look at the evidence, you’ll see that over the long run, most mutual fund managers have underperformed passively managed funds.
S&P Dow Jones Indices keeps a running scorecard of active fund performance in different countries, including Canada, called SPIVA. It consistently shows that, regardless of whether they invest in equities or bonds, most active managers underperform for most of the time.
The latest SPIVA data for Canada were released a few weeks ago, and they chart the performance of active funds up to the end of December 2023. What the figures show is that the great majority of funds have lagged the relative index once fees and charges are factored in, especially over longer periods of time.
Underperformance over ten years is even more pronounced. For example, 98.04% of Canadian Focused Equity funds, 97.56% of U.S. Equity funds and 97.60% of Global Equity funds underperformed the benchmark. Remarkably, on a properly risk-adjusted basis, not a single U.S. Equity fund domiciled in Canada beat the S&P 500 index over the ten-year period.
In fact, fund managers have found it so hard to outperform that, of the funds that were trading at the start of January 2014, just 61.33% of them were still doing so at the end of December 2023. That’s right, almost four out of ten funds failed to survive the full ten years.
Of course, it might still be worth investing in an active fund if you knew in advance that it’s likely to be one of the very few long-term outperformers. The problem is that predicting a “star” fund ahead of time is very hard to do, and past performance tells us very little, if anything, of value about future performance.
To illustrate this point, the SPIVA team examined the persistence of funds available to Canadian investors. Among Canadian-based equity funds that ranked in the top half of peer rankings over the five-year period to the end of December 2017, only 45% remained in the top half, while 55% fell to the bottom half or ceased to exist, at least in their own right, in the following five-year period.
To be clear, I’m not saying that active managers in Canada are any less competent than their counterparts in other countries. What the SPIVA analysis shows is that managers all over the world struggle to add any value whatsoever after costs. Distinguishing luck from skill in active management is notoriously difficult, but the proportion of funds that beat the markets in the long run is consistent with random chance.
Why do so few active managers outperform?
So why is active fund performance generally so poor? The most important reason is that beating the market is extremely difficult. Why? Because the financial markets are highly competitive and very efficient. Never before have investors had so much information at their disposal. New information is made available to all market participants at the same time, and prices adjust accordingly within minutes, or even seconds.
In the short term, then, prices move up and down in a random fashion. So, identifying a security that is either underpriced at any one time is a huge challenge.
Another reason why active fund performance tends to be so disappointing is that active managers incur significant costs. Salaries, research, marketing, the cost of trading and so on: all of these things need paying for, and it’s the investor who picks up the tab. Once all these costs are added together, they present a very high hurdle for fund managers. Simply put, any outperformance they succeed in delivering is usually wiped out by fees and charges.
There is, in fact, a very large body of academic evidence, dating back several decades, which shows that investors are better off avoiding actively managed funds altogether and using low-cost passive funds or ETFs instead.
Why do so many people still use active funds?
Why, then, in the face of overwhelming evidence that they shouldn’t, do so many investors continue to use actively managed funds? There are several reasons. First and foremost, banks and other asset managers have a vested interest in people investing in active funds because of the higher fees they generate. They also have large P.R. and advertising budgets to help promote them.
In addition, there are behavioural reasons why people are naturally drawn to active funds. For instance, research shows how investors are prone to overconfidence and optimism bias. They are also susceptible to narrative bias and outcome bias; in other words, they read about a fund manager with impressive recent returns and who appears to be highly skilled, and then choose to entrust that manager with their money just as their performance reverts to the mean.
Another reason why many people still use active funds is, frankly, that they like to gamble. Psychologically, the thrill of uncertainty and the potential for reward triggers the release of dopamine, a neurotransmitter associated with pleasure and excitement. Biologically, some individuals may have genetic predispositions that make them more susceptible to risk-taking behaviours.
Think in terms of probabilities
For all of these reasons, then, it can be very hard to resist the lure of active investing. So what’s the answer?
One suggestion is that you consciously try to feel more comfortable with uncertainty. Acknowledge how hard it is to predict the future and to beat the market. Do you honestly think you have the skill to outperform, or that you can spot someone else who has it?
Instead, start thinking about investing in terms of probabilities. Research has shown how, on a properly cost-and risk-adjusted basis, somewhere around 99% of funds underperform in the very long run, and that spotting, in advance, one of the very few exceptions is a very tall order. We can all see who the winners have been in the past, but what makes you think that you, or your adviser, have what it takes to pick a future star performer?
Focus on the three Cs*
Another suggestion I would make is that you focus on what Justwealth calls the three Cs of investing — cost, conflicts and competence.
Cost
Fund performance comes and goes, but fees and charges never falter. Active investing is substantially more expensive than passive investing. Expressed as percentages, fees and charges may look small, but, compounded over time, they can make a big difference to your net returns. By using passive funds or ETFs, you’re keeping more of your returns for yourself.
Conflicts
Using active funds adds conflicts of interest that investors can really do without, and some of which may not be immediately apparent. Generally, what’s good for the investing industry is bad for the consumers. So cutting out third-party intermediaries whose interests are not aligned with your own is a sensible step.
Competence
As we’ve seen, it’s difficult to tell whether an active manager possesses genuine skill. So why risk paying a premium for an active manager whose reputation may entirely be down to luck? Think as well about your own circle of competence. Investment consultants who devote their working lives to spotting the “best” funds cannot do it with anything like consistency; why should you do any better?
*To read more on Justwealth’s view of these Three C’s, please click here
Heed the advice of Warren Buffett
Finally, don’t just take my word for it. Instead, take some time to read what the world’s most famous investor, Warren Buffett, has said about active and passive investing in recent decades.
Not even Buffett has beaten the S&P 500 since the global financial crisis, and he has consistently stated that most investors should avoid investing actively.
“By periodically investing in an index fund,” he once wrote, “the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
If you think you know more about investing than Warren Buffett, feel free, by all means, to ignore his advice. But I respectfully suggest that you don’t.
Robin Powell is an award-winning journalist and campaigner for positive change in global investing, advocating better investor education and greater transparency.
For most of his career in mainstream journalism, Robin worked in broadcast news and current affairs. For 14 years he was a news reporter and documentary maker for ITV Central and network ITV News and ITV Sport. He went freelance in 2005, and spent seven years working mainly for Sky News and for The Politics Show on BBC1.
Robin is a member of the Chartered Institute of Journalists and was a Visiting Media Fellow at Duke University in North Carolina.
As well as The Evidence-Based Investor, he edits Adviser 2.0, a blog which explores the changes taking place within the financial advice profession. He is the writer and presenter of many highly-acclaimed online documentaries about investing, among others the titles Index Funds: The 12-Step Recovery Program for Active Investors, and Investing: The Evidence.
Robin is Founder and Executive Director of Ember Regis Group and its subsidiaries Regis Media, a niche provider of content marketing for financial advice firms and wealth managers with an evidence-based investment philosophy, as well as Ember Television, which produces and distributes broadcast-quality video content. Ember specialises in sharing new and disruptive ideas and in helping clients to become thought leaders in their field.
