Why do so many people continue to buy actively managed funds in the face of overwhelming evidence that they shouldn’t?
It’s a question I once put to former Vanguard CEO Bill McNabb. His response, which you can watch here, is enlightening. The biggest issue, he said, is that “the cost argument.. is counter-intuitive”. Consumers are conditioned to think, “the more I pay, the higher the quality (and) typically the better the results I get.”
Rolls Royce or Hyundai
He gave the example of buying a Rolls Royce or a Hyundai. “You’re definitely going to feel a difference in quality in terms of durability and so forth,” he said. “In investing… (it’s) just the opposite. That is a really hard behaviour for people to un-learn.”
I was reminded of that quote by a comment in a recent Money Marketing article on the new requirement for fund managers to submit an annual value statement. It came from Mark James at Square Mile Research.
“Costs are only part of the consideration,” he said. “It’s about value for money and that is often in the eye of the buyer, otherwise we would all be driving around in Skodas… Performance can make a huge difference.”
With respect, that is precisely what we would expect an investment consultant to say. “No consultant in the world,” as Warren Buffett has pointed out, “is going to tell you: ‘Just buy an S&P index fund and sit for the next 50 years’.” But Mark’s comment also completely misses the point.
Past performance means nothing
Of course performance is important. But what matters is future performance. Past performance, which is usually what consultants are referring to, tells us next to nothing about that. If anything, strong returns in the recent past make poor returns more likely in the future.
So, what does help us to predict the sort of returns we can expect from a particular fund? As ongoing research by Morningstar has consistently shown, the most reliable predictor of future returns is cost. In other words, the less you pay, the higher the net returns you can expect to receive.
Of course, you may strike lucky and identify a fund today that will outperform an equivalent index fund on a cost- and risk- adjusted basis over the next 25 years or more. But as David Blake at Cass Business School and others have demonstrated, the odds of doing so are about 100-1. Your chances of picking, in advance, a whole portfolio of long-term winners are not too dissimilar to buying a jackpot-winning lottery ticket.
Low cost, high quality
Back to the Skoda analogy (and let’s ignore the fact that Skodas today bear little resemblance to the cars that caused titters when I was growing up). It is in the industry’s interests to portray index funds as “cheap and cheerful”, a passable option for those who can’t afford active management. But the reality is very different.
Think about it. For just a few basis basis points you can access the returns of thousands of companies all over the world. By taking that option, you can pretty much guarantee, near enough, the full market return — with unerring consistency and for as long as you need it.
Viewed like that, index funds truly are the Bentleys and Rollers of the investing wold, or the super-efficient Audis or BMW if you prefer your posh cars German. And they’re typically available at a tenth of the cost of active funds, or even cheaper.
The industry spends billions making its latest expensive models look premium quality. We buy them almost as status symbols, and when they go wrong, we hold on to them for emotional reasons, until they eventually cost us a fortune.
All right, you won’t impress your friends pootling along with an index tracker. But let them laugh. The joke’s on them.
Picture: Justin Lim via Unsplash