There are many reasons why we’re extremely fortunate to live in a wealthy country like the UK in the 21st century. One of the biggest is the quality of the healthcare we now enjoy. Treatments are commonly available today which would have been inconceivable to our grandparents.
In fact, until the middle of the last century, many doctors and surgeons were more likely to harm their patients than they were to help them. So-callediatrogenic disease, or disease directlycaused by medical intervention, used to be a big problem.
Unfortunately, there are still some professions which arguably do more harm than good today.Research by Morningstar suggests that active money management might be one of them.
Proponents of active management often cite the manager’s ability todo something as a positive advantage that actively managed funds have over passive ones. For example, they can buy stocks they think are undervalued or sell those they consider undervalued; they can reduce their risk exposure when they’re expecting markets to fall, or increase it when they think they’re about to rise.
The case for doing nothing
But analysis by Morningstar’s Jeffrey Ptak and Madison Sargis implies that, in some cases, the ability to act is really a disadvantage, and that fund managers might deliver better returns if they didn’t do anything at all.
Ptak and Sargis looked at the performance of U.S. large-cap funds from the beginning of April 2013 to the end of March 2023. They started by compiling a list of all the stocks held by every fund in that category at the beginning of the ten-year period, and by recording the holding values of each stock. The total assets, spread across more than 400 funds, came to nearly $2 trillion. They referred to this as the “Do Nothing Portfolio”.
Next they used each stock’s monthly return to adjust its value, repeating for all 120 months. To arrive at the Do Nothing Portfolio’s value at the end of a month, they added up the value of the individual holdings. And then they derived monthly returns by comparing one month’s ending value to that of the previous month.
The researchers then compared the monthly returns of the Do Nothing Portfolio’s with the actual returns the funds delivered.
What they discovered was that the returns of the Do Nothing Portfolio and the aggregate returns of the active funds were virtually identical. The Do Nothing Portfolio gained 12.0% per year over the ten-year period, while the actual funds produced an annual return of 12.1%. In other words, all of the trading the active funds did made only the tiniest difference. But that doesn’t tell the full story, for two reasons.
Funds, on average, extracted value
First, these figures are gross returns, in other words, the returns achieved before the deduction of fees and charges. As well as having to pay higher annual management fees, investors in actively managed funds also incur transaction costs every time the fund trades; investors in the hypothetical Do Nothing Portfolio, on the other hand, would not have incurred any transaction costs at all.
Secondly, on a properly risk-adjusted basis, the researchers found that the active funds didn’t actually produce any alpha, or genuine outperformance. Instead theyextracted value from the investment process, and that’s before costs are factored in.
What all this means, effectively, is that US large-cap equity managers would have delivered better returns for investors if they had gone on holiday for the whole ten years and refrained from trading stocks altogether!
Could you have picked a winner in advance?
We shouldn’t read too much into these latest findings. This is just one class of funds, US large-caps, and one ten-year period. But the crucial point this study emphasises is that, in investing, doing nothing really does pay off.
“While active large-cap managers made thousands of trades worth trillions of dollars over (this) period,” Ptak concludes, “it doesn’t appear those transactions conferred significant benefits to investors.”
Of course, there will always be some active funds that do outperform, and these are just the funds that asset management firms promote and that the financial media tends to write about.
Anyone can tell you who the winners have been in the past. But identifying, in advance, a fund that will outperform in the future is another matter entirely. Of the 2,178 US large-cap funds that existed at the start of the period Morningstar looked at, only 354 survived the whole decadeand delivered a higher risk-adjusted return than the Do Nothing Portfolio did. That figure fell to 92 funds after fees. In other words, ex ante, you had about a one-in-24 chance of picking a genuine outperformer.
A risk you needn’t take
Thankfully, you just don’t have to take that sort of risk. By simply choosing the slow and steady route to wealth, investing in passive funds (or at least broadly passive), and resisting the temptation to trade, especially in a volatile market, it’s perfectly possible for ordinary investors to outperform most professional fund managers.
Just to clarify, there will always be a place for active managers. Many of them are highly intelligent and conscientious people. But before you decide to invest with one, bear in mind that properly beating the market after costs is extremely difficult. And remember: there’s a strong possibility that, like physicians of old, the manager you choose will end up doing rather more harm than good.
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