Two warnings for investors choosing active funds
- Robin Powell
- Aug 26, 2024
- 4 min read
Choosing an active fund can seem like a smart move, especially when a fund has delivered strong results in the past. But past performance is rarely a reliable guide to the future, and investors risk being misled by short-term success.
Behavioural finance expert Joe Wiggins explains why two common traps catch out even experienced investors. The first is our tendency to chase recent winners. The second is the challenge of staying invested when performance inevitably lags behind the market.
In this video, we explore what really matters when choosing an active fund. They also explain how high fees and survivorship bias distort the picture for investors trying to separate skill from luck.
Three key takeaways:
1. Don’t trust past performance
Strong returns in the recent past often lead investors to believe a fund manager has skill. In reality, these results are frequently driven by luck and tend to reverse over time.
2. Be prepared for underperformance
Even highly skilled managers, including Warren Buffett, have endured long periods of lagging behind the market. Most investors won’t stick around that long, which undermines any chance of success.
3. Understand the hidden costs
Active funds usually charge much higher fees than index funds, and these costs quietly erode long-term returns. Survivorship bias also gives a misleading impression of how many funds actually succeed.
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Transcript
Robin Powell: While index funds simply aim to track the market, actively managed funds try to beat it.
That might seem attractive, but it’s not that simple.
Behavioural finance expert Joe Wiggins says there are two main things to think about before investing in an active fund.
Joe Wiggins: One is that our tendency is to focus on past performance. So we're drawn towards managers who generated strong returns in the recent past, which is an incredibly fickle guide to the future. Returns at best. And actually, the more extreme positive returns have been generated in the past, the higher the probability of poor returns in the future.
So you’re ironically drawn towards managers with stellar records in the past. That increases the odds of disappointing returns in the future. That's a fundamental issue that we have so, if we're going to invest in active funds, it needs to be more focused on skill rather than past performance, which can be highly volatile and random.
RP: So, don’t be swayed by the fact that a particular fund has recently produced excellent returns.
The second thing Joe Wiggins urges investors to keep in mind is that staying invested for the long run in whichever active fund you choose can be very challenging.
JW: If investors want to invest in an active fund, they need to understand the payroll implications of doing so. And one is, you will go through significant periods of underperformance. Even if you look at Warren Buffett's track record at Berkshire Hathaway, it went to significant periods of underperformance against the S&P 500. So the best investor of his generation probably went through long periods of underperformance, periods over which most active fund investors would fire a fund manager and so on.
Typical time horizon, as most active fund investors would have fired Warren Buffett at some point.
RP: Most active funds underperform most of the time.
But it’s not because the managers aren’t highly intelligent and hard-working — most of them are. It’s mainly down to the higher fees that active funds charge.
JW: When people see the data on, active management success against the index or passive options. There's often a narrative around it being, active managers don't have skill that they're useless. Then they're not capable investors. That's I think it's a bit of a misnomer. The real difference is fees.
There's a yawning gulf between the fees of a passive strategy or small beta strategy, and a fully fledged active strategy and although they may look relatively minimal over any given year, the compound impact of that fee differential will be profound through time.
RP: You also need to remember that the fund industry and the media sometimes give the impression that more funds outperform the market than actually do.
That’s usually down to survivorship bias.
JW: So if you think about that to the fund management industry, you'll see managers who have underperformed they will lose their jobs or funds will be closed down or will be merged with other funds and perform better. So you're left with a biased sample of managers who generated a strong track record. So that can put a flattering view on the overall results of the group.
I think the key thing when you think about survivorship bias is understanding it is an issue. Whenever you're looking at data, you're looking at performance tables or you looking at aggregate performance of the group, understanding whether it's been controlled for that or whether it's heavily biased towards, the survivors in the group, the better performers in the group.
RP: In short, be naturally sceptical. Making sensible fund choices is hugely important. If in doubt, seek professional financial advice.
HOW TO FUND THE LIFE YOU WANT
If you want to learn more about saving for retirement, we recommend you read the award-winning book How to Fund the Life You Want by TEBI founder Robin Powell and Jonathan Hollow.
The book is published by Bloomsbury and is primarily aimed at a UK audience.
Buy the book here on Amazon, or, if your prefer, here on bookshop.org.
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