I don’t know any other way to say it.  Active management is a cruel joke perpetrated on naïve investors.

Dismal performance

Every year, only a minority of actively managed funds outperform their risk-adjusted benchmark. Stellar performers have a dismal record of repeating their outperformance.  The odds of a portfolio of index funds outperforming a portfolio of actively managed funds is strikingly high.

As Larry Swedroe notes in this blog post, every year active managers attempt to explain their inability to beat the performance of comparable index funds with different excuses.   He correctly observes: And each time, those explanations are exposed as lame excuses, without any rationale to support them.

Hidden impact of taxes

There’s a reason most mutual funds only advertise their pre-tax returns.  Taxes and other fees sharply reduce the net returns actually earned by investors in actively managed funds compared to index funds.  One study found that investors in taxable accounts “kept only 47% of the cumulative return of an average actively managed equity mutual fund, but they kept 87% in a market index fund…”

That’s a huge difference.

Tax-efficient investing isn’t rocket science.  Heed this sage advice in a white paper co-authored by Rob Arnott, Vitali Kalesnik, and Trevor Schuesler:  Buy exchange-traded funds.

The authors found that over the 25-year period studied, 53.3 percent of ETFs made no capital gains distributions, compared to only 4.9 percent of mutual funds.  By eliminating these distributions, ETFs sharply reduced the tax burden to investors.

The next time someone recommends an actively managed mutual fund to you, ask this question:  What were the after-tax returns of that fund?

The “cruel joke” costs a fortune

With active management, you pay a premium for the likelihood of underperformance.  One analysis added all the costs of a typical actively managed fund and compared it to the costs of a comparable index fund.  The annual cost of the actively managed fund was a whopping 2.45 percent, compared to 0.41 percent for the index fund.

In the aggregate, investing in actively managed funds costs investors around $80 billion a year.

Don’t continue to be a victim of the “cruel joke” of active management.  You now know better.

Resource of the week

This academic paper, authored by Kenneth R. French, exposes the true cost of active management.