There’s No “Active vs. Passive” Debate

Do you see the empty chairs in the photo?  That’s how many informed investors would show up for a debate about whether to invest in actively managed funds or index funds.

There is no “debate.”  Anyone who knows the data understands actively managed funds are simply a scheme to transfer your wealth into the pocket of fund families that don’t have the expertise to “beat the market.”

When confronted with the data, they engage in an elaborate rationalization, filled with double-talk and often errant nonsense.

Here’s one glaring example that speaks volumes.

Extolling high fees

A recent article in The New York Times discussed the high fees charged by Baron Funds.  The founder of Baron Funds, Ronald S. Baron, is a billionaire (which harkens back to the title of Fred Schwed’s classic book, Where Are the Customers’ Yachts?).

Mr. Baron is proud of the high fees charged by his funds, stating: “If you want the lowest fee, you should not invest with us.”

Performance of Baron Growth

After publication of this article, financial journalist and author, Larry Swedroe, ran an analysis of Baron’s flagship fund, Baron Growth (BGRFX). It has an expense ratio of a whopping 1.3%.  It manages more than $6 billion. Morningstar classifies the fund as a mid-cap growth fund.

Investors who believe Baron has the ability to beat the market could purchase Baron Growth and pay 1.3% of the amount invested, or they could buy an exchange traded fund, that tracks the mid-cap growth index.  The i-Shares S&P Mid-Cap 400 Growth ETF would be the comparable ETF.  It charges a puny 0.15% -- a fraction of the cost of the Baron fund.

For the past decade (ending December, 2017), the ETF outperformed the Baron fund by a shocking 2% a year!

Lower cost.  Higher return.

Attempt at justification

I reached out to Baron and asked for an explanation. I received a long missive that discussed, among other things, Baron’s view that there are “inefficiencies and mispricing opportunities that can be garnered over the long term," noting its low turnover compared to the average small cap mutual fund, and reaffirming its belief that ETFs will not “outperform our fundamentally-backed approach over the long term.”

Baron also notes its fund “has outperformed its benchmark, the Russell 2000 Growth Index, most of the time (76%) over rolling 10-year periods since the Fund’s inception” and that it added value during the challenging market environment from December 31, 1999 to December 21, 2008.

It concedes its underperformance over the past decade, stating:  “While active management, in general, has underperformed passive over the past decade, it is important to note that the performance of active and passive managers tends to be cyclical over the long term.”

The odds are daunting

The SPIVA reports track the performance of actively managed and index funds over the short and long term.  This performance does not appear to be “cyclical”.  According to the U.S. Scorecard: Mid Year-2017, “…over the 15-year investment horizon, 93.18% of large-cap managers, 94.40% of mid-cap managers, and 94.43% of small-cap managers failed to outperform on a relative basis.”

You could get lucky and find an actively managed fund that outperforms its benchmark, but I don’t like your chances.  If you decide to try, here’s a tip:  You can tilt the odds in your favor by selecting the lowest cost actively managed fund among those you are considering.

High fees may be good for Mr. Baron, but they contribute directly to underperformance.

Resource of the Week

The SPIVA reports should be required reading for all investors.  Start with this one.

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