THOSE OF US WHO GREW up in the 1950s watched Howdy Doody on that large, newfangled box with a picture tube and knobs. The show’s host was Buffalo Bob, who enthusiastically proclaimed Wonder Bread “helps build strong bodies eight ways.”
Subsequent nutritional research debunked that claim, and the government induced Continental Baking to add back the healthful ingredients that its processing methods were removing. The new wrapper proclaimed “enriched” Wonder Bread, even though the firm was simply replacing what had been there before.
That brings me to investing. Instead of Howdy Doody, many of us now watch CNBC, where talking heads expound on the virtues of picking stocks and making market bets. Does such active involvement help strengthen our portfolios eight ways? Consider these eight dubious contentions from fans of active management:
1. Index funds produce average—and hence unsatisfactory—returns.
Remember the game show Who Wants to Be a Millionaire? If your goal is seven figures, start making steady monthly contributions to a broad stock market index fund when you’re young. Live your life, pursue your dreams and don’t mess with your portfolio’s compounding. By the time you reach retirement age, there’s a good chance you’ll have your wish. How’s that for average?
2. Results for most index funds diverge from their underlying indexes.
Consider one of the most popular exchange-traded index funds, Vanguard Group’s S&P 500 ETF (symbol: VOO). In 2021’s soaring market, the Vanguard fund’s 28.6% total return was virtually identical to the index’s 28.7%. In last year’s tumultuous down market, the corresponding figures were -18.2% and -18.1%. What divergence are they talking about?
3. The higher cost of active funds is insignificant.
We can quickly dispense with this blatant untruth. Research has linked higher expense ratios to lower fund returns, and the longer the time horizon, the greater the impact. Suppose you invested $100,000 at a modest 4% a year—before costs. Over 20 years, you’ll end up with almost $10,000 more if you pay 0.25% in annual expenses rather than 0.5%. And, of course, most active funds charge far more than 0.5%.
4. Money managers’ massive research capability gives them a big leg up on index investing.
What leg up? It’s the outrageous cost of that research albatross that explains much of why portfolio managers consistently underperform.
5. Active funds protect investors by shifting in and out of market sectors and moving between stocks and cash.
What good is all that activity if active managers have no proven skill in the first place? On top of that, investors shouldn’t have to pay a fee for that part of a stock fund that sits in cash. We’re perfectly capable of hoarding our own cash.
6. Active managers can exploit market inefficiencies among small-cap stocks and emerging markets.
Here we can consult the last word on active vs. passive fund performance, the S&P Dow Jones Indices’ SPIVA report. In 2021’s rising market, 71% of active small-cap funds failed to beat their index bogey. Likewise, in 2021, 65% of active managers underperformed when trying to pick among emerging markets’ less followed and less liquid stocks. What about last year’s tumbling market? In the just released 2022 data, active funds succumbed 57% of the time among small stocks and 76% in emerging markets.
7. Directionless and choppy markets offer special opportunities for stock pickers.
I can’t turn up any evidence to counter or support this claim. Andrew Marchant, chief investment officer at financial advisors Minchin Moore, refers to the stock-picker story as a “nice idea that has no grounding in actual fact.” Given the inability of portfolio managers to perform well in up and down years, it seems highly unlikely they have a hidden talent for plucking promising stocks from a directionless market.
8. Actively managed funds have consistently outperformed their corresponding benchmarks.
Are they kidding me? Let’s get real by going back to that definitive SPIVA report. In 2021, just 20% of all active U.S. stock funds outpaced the S&P Composite 1500 Index. Active managers’ results “improved” to 50% in 2022, their best showing since 2013. But it’s the long-run results that are truly telling. More than 92% of U.S. stock funds have failed to beat the index over the past 20 years. Adjusted for volatility, that figure rises to an unconscionable 97%.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.