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Why are Actively-Managed Funds Popular?

June 6th, 2006 · 8 Comments

Academic research has amply demonstrated that actively managed funds as a group badly trail their benchmark indices. So, why are actively managed funds so popular with trillions of dollars invested in them?

My guess is that the vast majority of the investing public just buys a fund in the hottest sector sporting blockbuster recent performance numbers. They don’t pay attention to the costs but are sold on the recent performance numbers. The thinking goes something like: “Wow. This fund returned 89% last year. I got to get in on that!”

A fascinating article on Knowledge@Wharton describes a study in which test subjects (MBA students and undergraduates) were asked to choose between different index funds that tracked the S&P 500 but had different fee structures based on the information given to them. The results show that even if the fee structure is clearly explained, over 80% of the subjects do not invest in the fund with the lowest fees. The investors who were given a detailed prospectus or a “returns sheet” that highlighted the fund’s returns since inception fared even worse. The depressing conclusion is that investors underestimate the impact of fees even when it is clearly spelled out.

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8 responses so far ↓

  • 1 FMF // Jun 7, 2006 at 6:57 am

    “My guess is that the vast majority of the investing public just buys a fund in the hottest sector sporting blockbuster recent performance numbers. They don’t pay attention to the costs but are sold on the recent performance numbers. The thinking goes something like: “Wow. This fund returned 89% last year. I got to get in on that!””

    I agree with you 100% — strange though it is!

    Why people don’t just take 15 minutes and figure out a better (and easier) way to invest (like in index funds) is a mystery to me.

  • 2 Kanwal // Jun 7, 2006 at 10:39 am

    We live in a world of instant gratification. No one
    wants to take the time (or has the time) to sit down
    and look into investing properly.

    Hopefully your blog will help people become more
    aware.

  • 3 Anonymous // Jun 7, 2006 at 11:18 am

    Why are Actively-Managed Funds Popular?…

    Canadian Capitalist’s guess is that the vast majority of the investing public just buys a fund in the hottest sector sporting blockbuster recent performance numbers. He also discusses some academic studies regarding fund fees….

  • 4 Joe // Jun 8, 2006 at 7:51 am

    I took an investments course and my prof said that actively managed funds are popular because they have less downside risk. In other words, you money will not bounce around as much, triggering panic selling for a lot of people.

  • 5 Canadian Capitalist // Jun 8, 2006 at 8:40 pm

    Joe: I disagree with your prof. because there is no evidence that managers as a group are able to time the markets successfully. In any case, in a bear market a manager is forced to sell and raise cash to meet the flood of redemptions.

  • 6 silverm // Jun 8, 2006 at 11:39 pm

    Hi Canadian Capitalist, I was wondering why all those Actively Managed funds vs Index funds talks tend to end just short of closet index funds?

    A quote from John Bogle of Vanguard:
    “Indexing has also forced managers of mutual funds holding portfolios of large-capitalization stocks to minimize their risk of materially departing from the stock market’s return, the better to stabilize cash flows from investors— essentially, therefore, setting marketing strategy. Of the 100 largest equity funds, fully three-quarters have market correlations of 0.90 or above, including one-fourth at 0.97 to 0.99. (We call these funds “closet index funds.”)”

    If we accept that 75% of actively managed funds as simply closet index funds, can we put any faith in all those studies of actively managed fund under performance?

    There have been may exceptional managers in the past and present like Peter Lynch, Irvin Michael, John Neff, Ralph Wanger, Sir John Templeton, Peter Cundill, Francis Chou, Tom Standly, Jim O’Shaughnessy and Eric Sprott? I’m just curious why have the debate at such a high level? i.e. average of these can’t beat the average of that. My view is that we have a nice group of managers to choose from, but unfortunately closet index funds and other less able managers are dragging the average down for the industry and contaminating the studies. The active vs index debate is over generalizing (IMHO), therefore the conclusion doesn’t help me in my real life investing.

  • 7 Free Money Finance // Jun 9, 2006 at 3:31 am

    Star Money Articles for the Week of June 5…

    Here are interesting posts and news this week from the MoneyBlogNetwork members and beyond: AllFinancialMatters tells us how to compute compound annual growth rate. MightyBargainHunter asks whether you should pay it down or ING it. Five Cent Nickel dis…

  • 8 Joe // Jun 9, 2006 at 9:45 am

    I think his argument was that money managers pick stocks that have less downside risk than actually being able to time the market. In fact, mutual funds dont’ really play the timing game – they claim to invest in “only the best” stocks. It may be worth comparing the downside volatility of an index fund with a active mutual fund.

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