The appearance of winning is addictive. It’s a trend playing out in politics right now, but also one that impacts the retirement portfolio.
That’s why when clients come to Robert Oliver’s office to seek financial advice, they often start with some form of this question: “How do I beat the market?”
When Oliver hears that, he knows he’ll need to explain “what it means to try and beat the market,” he says. “They hear about how their friends or family members beat the market. It’s usually not aligned with reality.”
That’s because the clients haven’t heard the full picture. While one investment did wonderful, the family member doesn’t share the 10 others that performed poorly. Beating the market also includes much more risk and expense to the portfolio. And if trying to do that via a mutual fund, it means looking toward actively managed funds, where portfolio managers pick and choose the investment strategy.
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According to a survey from Capital Group, 70 percent of millennials and 80 percent of baby boomers believe they “can outperform the market and do better than average.”
The tactic used to manage this feat: nearly 70 percent of those surveyed at each age group say they would use a mix of index and actively managed funds.
But the goal of saving and investing isn’t meant to beat the market. Individual investors don’t have the tools and technological capabilities to do that. Instead it’s better to move with the market.
Here’s why it’s time to reconsider that dream of beating the market using managed funds.
The fees mount up. While it’s easy to think that there’s some sort of control in the market, there’s nothing a financial advisor can do to manipulate it. That’s why Oliver, who runs Oliver Financial Planning in Ann Arbor, Michigan, tells his clients that they should focus on “what they can control.” And that’s cost.
To keep costs low, passively managed funds remain the best option. While actively managed fund expense ratios have fallen over the past five years due to the pressure of index funds, they still remain near 0.8 percent on average. Index funds come in at 0.2 percent, according to Morningstar.
This can have a dramatic impact over time as even a half percent in fees can be the difference in tens of thousands of dollars over a lifetime, depending on how much is invested.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
The fee situation worsens because actively managed funds don’t outperform the lower-cost index option. Removing fees from the equation, only one asset group’s actively managed funds saw performance as a whole do as well or better than the benchmark over 50 percent of the time, according to a Morningstar study.
But if there’s still an urge to take a stab at picking the right actively managed fund, remember that the lower-priced actively managed funds performed far better than the higher-priced options.
There’s some positive use in certain areas of the market. Mitch Zides, an advisor at Constant Guidance Financial in North Attleboro, Massachusetts, says he often suggests active management funds for his clients’ portfolio. But he usually only looks for these options in areas where there’s a lack of deeper analysis, like junk bonds or small-capitalization companies. In these spots, there’s “less efficient markets,” since fewer eyes evaluate the firms on a regular basis.
Everyone has an eye on Apple (ticker: APPL), while not many people may know about Teleflex ( TFX), a medical device maker, so the thinking goes.
The active management approach also works in the bond market, where a manager could react to the threat of higher interest rates, for example, while index funds can’t.
But even in areas where there are fewer eyes, it’s a tricky path to walk. More than 80 percent of small-cap managers underperformed the small-cap benchmark, once fees are accounted for, according to a recent report by the S&P Dow Jones Indices.
Part of the reason for that high level of underperformance is because the market is currently doing OK. In weaker markets, active managers tend to perform better than during bull runs. “Some do a very good job in protecting as markets slow down and correct,” Zides says.
Even then, how does one pick the right fund?
The performance often lags. Picking the right active manager is often based on past results. But looking “at performance of actively managed funds, there’s no persistency,” Oliver says.
University of Chicago researcher Eugene Fama and Tuck School of Business at Dartmouth’s Kenneth French studied whether luck or skill was involved when determining the success of funds. They found that when accounting for expenses, returns didn’t differ from the performance of benchmarks. Essentially, they’re picking the same companies the index would.
When accounting for luck, they found some funds outperformed while others didn’t, but there was little evidence of fund managers that outperformed due to skill. The truly skilled fund manager may exist, but it’s overshadowed by all the other options.
That’s the other problem with performance: Picking the right person must come before he or she beats the index.
[See: 10 Long-Term Investment Strategies That Work.]
Unfortunately, says Oliver, “there’s no way to identify them in advance.”
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3 Reasons to Stop Trying to Beat the Market originally appeared on usnews.com
