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A WHILE BACK, I WAS speaking with a mutual fund manager. In describing one of his fund’s stocks, he noted, “I owned it for a while, then I sold it, but then I bought it back.” It was a surprising comment since frequent trading is, in most cases, unproductive. Indeed, Warren Buffett has often said that his preferred holding period for an investment is “forever,” and many see that long-term mindset as crucial to his success.
At the same time, Buffett’s “forever” strategy hasn’t always worked out. He acknowledged making a mistake in owning IBM, which has seen its stock flatline for 10 years. Buffett’s Berkshire Hathaway also owned big positions in Wells Fargo and Tesco before corporate malfeasance took both of these companies’ stocks down. In all three cases, Buffett chose not to hold forever and finally exited these stocks.
Buffett’s experience indicates that holding any investment indefinitely can pose problems. On the other hand, there’s data showing that trading too frequently can also be detrimental. Brad Barber and Terrance Odean, for example, wrote a well-known paper titled “Trading Is Hazardous to Your Wealth.”
As an individual investor, what should you conclude from these seemingly contradictory findings? In a recent set of studies, researchers at Morningstar looked at this question.
In one study, Morningstar’s team analyzed 400 actively managed large-cap mutual funds. The researchers compared the funds’ performance over a 10-year period to an alternative scenario in which the funds’ holdings had been held static for those 10 years. They referred to these alternatives as the “do-nothing portfolios.”
The result? Some funds would have done worse if their holdings had been frozen in time, while others would have done better. On average, though, the difference would have been negligible: Before factoring in costs, the actual funds gained 12.1% a year over the 10 years ending March 31, while the do-nothing alternatives would have notched 12%. The difference was almost immaterial—but that was before fees.
Since actively managed funds carry annual fees of nearly 1%, the net effect was that these funds’ managers detracted more from their funds’ performance than they contributed. As Morningstar put it, these fund managers would have been better off taking a vacation—”a long one.”
In another study, Morningstar examined tactical asset-allocation funds. Unlike funds that pursue a single investment strategy, such as sticking with large-cap growth stocks or intermediate-term corporate bonds, tactical funds have the latitude to switch among asset classes as their managers see fit. If they see a recession coming, for example, they might switch more of the funds’ assets into bonds. For these funds, Morningstar asked the same question: How would these funds have fared if their holdings hadn’t changed at all over 10 years—in other words, if their managers had gone on vacation?
The result: Over the same 10-year period referenced above, tactical funds earned a modest 2.3% a year, on average. But had the managers done nothing at all for 10 years, their funds would have gained twice as much. As Morningstar put it, “They came. They saw. They incinerated half their funds’ potential returns.”
I see two lessons in these results. First, when in doubt, be like Buffett. Yes, you can make a mistake by hanging onto an investment for too long. But on balance, it’s better to maintain a long-term mindset toward your investments. That means, of course, hanging on through the market’s usual ups and downs, and I’ll acknowledge that isn’t always easy. But as the tactical fund managers proved, the alternative can be much worse. It’s virtually impossible to make successful trades based on economic or market predictions. This risks “incinerating” returns. Instead, in my view, investors are better served by choosing an asset allocation that they can live with through the market’s ups and downs.
The second lesson we can learn from these studies: Fees really matter. The late Jack Bogle, founder of Vanguard Group and an index fund pioneer, often said that he didn’t see active management as a problem per se. Rather, the problem was the high fees that most active managers charge. That’s the fundamental reason investors are, in my opinion, better off avoiding actively managed funds and instead opting for very low-cost funds, which usually means index funds.
What if an active fund manager has a solid long-term track record? Should you still avoid it? Certain funds, such as Fidelity Contrafund (symbol: FCNTX) and Dodge & Cox Stock Fund (DODGX), have enviable records and reputations to match. Are they the exception to the rule and worth a portion of your savings? It’s on this question that Morningstar’s new research is most helpful.
Look at the performance over the past decade of the 10 largest domestic stock funds compared to their do-nothing alternatives, and you’ll see that the results are nearly evenly split. Six underperformed the do-nothing alternatives. But the other four added value—even after fees in some cases. That might lead investors to conclude that it’s worth owning a few actively managed funds. At first, that might seem logical. The challenge, though, is that fund performance isn’t static. Yes, some funds do have streaks of excellent performance, but no fund has exhibited permanent outperformance.
Standard & Poor’s tracks the mutual fund industry closely and can quantify this. In its most recent Persistence Scorecard, fewer than half of mutual funds that had above-average performance over one five-year period were able to maintain those above-average results in the following five-year period. Funds with really exceptional performance—in the top quartile—demonstrated even less of an ability to maintain that top-tier performance.
Why is it so hard for fund managers to do better than their indexes? It doesn’t seem very hard to spot up-and-coming winners like Google and Apple. As it turns out, it isn’t very hard. Fund managers actually do a great job picking stocks. The problem is on the other side of the transaction, and that’s what drives their underperformance.
In a 2021 paper titled “Selling Fast and Buying Slow,” researchers looked at the track records of professional fund investors and made this discovery: “While there is clear evidence of skill in buying, selling decisions underperform substantially.” In other words, investment managers can spot winners. But they don’t do a good job in choosing when to sell those stocks. Sometimes, they sell too soon and miss out on future gains. Other times, they sell too late, after a stock has dropped. That’s why, according to the data, it’s best for investors to keep things simple—and steer clear of actively managed funds.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Another informative article, Adam. Thank you. Another challenge that I see for the active managers is investor behavior. Since the index funds have been given “benchmark status”, avowed indexers will stick with them long term, and not jump out. However, the active managers (courtesy of those in the analytics business, like Morningstar and Lipper) are often, constantly, compared to the index, and their nomadic investor base is more inclined to jump out when they underperform, and jump in when they outperform. In either case, it adds to their challenge, because they’re either trying to invest with the challenge of redemptions, or have more money than ideas with strong inflows, and sitting on the cash while they search works to deteriorate their results — which leads to index underperformance and the cycle repeats.
Between the challenges of the cost differential, and investor behavior, I don’t see how an active manager can consistently outperform an index fund.
Third lesson. If you invest in broad based index funds there is no need to time an exit because of the ill fortune of a single company or sector.
Thanks Adam.
While it isn’t something I would consider doing, your article and the research you cited made me wonder about a strategy of firing your advisor immediately after she or he established your portfolio so that you could take advantage of their superior skill in buying stocks and avoid their inferior selling decisions.
A question I’ve been pondering lately: Are those active managers able to reduce the volatility of the funds they manage? For example, I would assume that a “tactical” or “dynamic” asset allocation would have the primary goal of reducing wide and wild swings in value, so as to aide in a more uniform distribution over a given period of time. While this wouldn’t really matter for a portfolio that’s simply in its accumulation phase, it could be an important benefit for a portfolio that’s in its distribution phase. Even if such a strategy sacrificed a point or two of return relative to a static (do-nothing”) benchmark, the reduced volatility might still be a worthwhile (and cost-effective) benefit to that account holder.
Holders of Dodge and Cox Stock Fund before and through the GFC would like a word. By excluding their disastrous performance through that period you are doing a great disservice to your readers.
“Dodge & Cox Stock Fund (DODGX), have enviable records and reputations to match.” – not to this HD reader.
Thanks, and that’s a good example of the challenge with actively-managed funds: They might have exceptional track records in some periods, but then give up all those gains in the following period. That’s one of the reasons big fund companies have dozens of funds. That way, at any given time, they can promote the handful of funds that have exceptional records. I won’t pick on any one fund company, but check out the big firms’ ads, and you’ll notice that they emphasize the same set of funds even though they have 50 or 100 funds in their stable.
This reader is thrilled with DODGX and understands its underperformance vs the S&P is cuz it’s a value fund, not cuz it’s not a great fund. Their 3, 5, 10, and 15 year performance vs their peer group is excellent. I’ll continue to own it, likely forever.
By the way, a reminder that for active funds, we buy the fund manager(s), not the fund.
This is another good point: “Good” or “bad” performance needs to be viewed is comparison to a relevant benchmark. Again, I won’t pick on any one company, but some fund firms have a habit of choosing benchmarks that are easier to beat.
“some fund firms have a habit of choosing benchmarks that are easier to beat.”
This is why M* is a valuable site for fund comparisons. I think they use appropriate benchmarks and indices.
Adam, thank you for a clear, persuasive argument against actively managed funds. The Morningstar study is a big road sign warning of danger ahead.