For decades, it has been Wall Street’s best-kept secret that actively managed funds typically generate worse returns than their benchmark. Every year there are research studies done to measure portfolio managers’ effectiveness, and every year the results tell the same story. On average, active management costs but it does not pay.
Here’s the year-end 2016 report from Morningstar showing the success rate of active funds:
If you don’t like reading charts, just try their key takeaways on for size:
- In general, actively managed funds have failed to survive and beat their benchmarks, especially over longer time horizons.
- The average dollar in passively managed funds typically outperforms the average dollar invested in actively managed funds.
- Investors would greatly improve their odds of success by favoring low-cost funds, which succeeded far more often than high-cost funds over the long term.
It’s no wonder the average investor’s returns lag even below inflation!
So, why are active managers mostly unsuccessful? We propose a number of reasons.
First off, they cost more money. Actively managed funds have a higher expense ratio, which raises the hurdle rate to profit—not to mention excess gains, known as alpha.