In pursuit of mediocrity or the high cost of active management

This post originally appeared at the Amazon Money & Markets blog. Last month’s post looked at some lessons we can learn from Wall Street-themed moves. Enjoy.
AMZNMM 300x86 In pursuit of mediocrity or the high cost of active management

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In the United States we don’t take well to the idea of settling for mediocrity. While the amiable slacker is a archetype in popular culture he is not what most aspire to. The same is true when it comes to our investing. In our minds we aspire to be a swashbuckling hedge fund manager bucking conventional wisdom. In short, we don’t aspire to be an index fund manager.

However when it comes to our investments that impulse works against us. I would argue that the costs, both explicit and implicit, of pursuing active returns are in higher than many believe. A better approach for the majority of investors to follow is a low impact, tax-aware investment strategy that focused on low costs, index funds, broad diversification, portfolio rebalancing. This fits with what I write in Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere which advocates a modest (and humble) approach to investing:

For most investors, investment mediocrity is an eminently achievable and worthy goal. The great thing is that investment mediocrity is now easier and cheaper to accomplish than at any other time in history.

If that is fact the case why is that so many investor spend so much time pursuing active returns? As is the case with so many things in life there are likely multiple explanations for why Americans, and others, are so wedded to the idea of active (and high cost) investing.

First off, indexing seems downright un-American. As noted before no one aspires to mediocrity. However this sort of approach if followed correctly will in likelihood lead to above average returns. Burton Malkiel and Charlie Ellis in their book The Elements of Investing note how this comes about:

That’s why critics like to call indexing “guaranteed mediocrity.” But we liken it to playing a winner’s game where you are virtually guaranteed to do better than average, because your return will not have been dragged down by high investment costs.

The second element is that sadly many investors really don’t understand their own performance or the costs that they are incurring along the way. The fact is that nearly every study of active mutual fund managers show that on average after expenses they underperform their respective benchmarks. Similarly Barry Ritholtz at The Big Picture writes:

One of the things that has become so obvious to me over the past few years is how unsuccessful various players in the markets have been in their pursuit of Alpha. We know that 80% or so of mutual fund managers underperform their benchmarks each year. We have seen Morningstar studies that show of the remaining 20%, factor in fees, and that number drops to 1%.

That is why the mutual fund industry is so wary of the rise of the low-cost ETF. Ultra-low cost index ETFs highlight now more than ever the gap between the promise of active management and its reality.

A third reason why we as investors get caught up in the performance game is the media. It is a bit a trope these days to blame the media for the ills in society. However in the case of investing the goals of the financial media work directly at cross-purposes of the long-term, patient investor. The goal of the media, financial or otherwise, is to garner ratings, page views, etc. It is not necessarily to inform. The media succeeds these days when it plays to our own inherent biases.

That is why the seemingly all-knowing pundit is a staple of political panels and financial television. They provide a useful service to the producers despite what is in all likelihood a poor track record. Rick Ferri the author of The Power of Passive Investing in a blog post writes:

The more things change, the more they stay the same. There weren’t any market timing experts in the 1980s and 1990s, and there haven’t been any since. There are no experts at predicting markets – there are only experts at marketing predictions.

Guests go on financial television to market their wares. Financial television is happy to have some one to fill the time. Once you recognize that everyone is fact talking their own book you can better focus on what matters for your “own book.”

Fourth it may be that simple solutions aren’t all that appealing to us. Despite what we say we end up with complex (and expensive) solutions. Why is that? Carl Richards the author of The Behavior Gap argues at The Bucks Blog that:

We think simple should be easy.

It’s like the guy who goes to the doctor and says he doesn’t feel well. There must be something wrong with him that a pill could fix. But all the doctor says is, “Get more sleep, eat healthier food and exercise three times a week.”

It’s the simple solution, but it’s not easy.

Simple solutions require us to avoid temptation. We want to buy the hot fund. We want to sell the asset that is underperforming. The problem is that historically the subsequent performance puts us in a worse position. Chuck Jaffe at Marketwatch looks at this phenomenon and notes how a dedication to portfolio rebalancing helps us avoid these rash decisions that end up costing us money.

In the end it may matter less that we pursue indexed portfolios than simply focus on the costs we are incurring along the way. For example Dan Culloton at Morningstar notes how some of the leading voices in favor of indexing note the potential to find managers that outperform. However the key point is that you cannot overpay for the privilege. He writes:

It’s tough to beat low-cost index funds. But just as it was wrong to deride passive investing as settling for average results, it’s a mistake to equate all active funds with the average active fund.

Time spent trying to find that above average active fund is time not spent in other pursuits. There will always be investors in hot pursuit of what is working now. Which is great. They are in a very real sense doing us all a favor. However for the vast majority of investors a simple, stripped down, low-cost approach to investing is in some sense the best of both worlds. It has the potential to generate above average, albeit mediocre, returns while avoiding the high implicit (and explicit) costs of active investment strategies.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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