The Securities Industry Is Laughing At You

08/01/2017 05:19 pm ET

A wonderful podcast was recently broadcast by freakonomics.com. The producers assembled the smartest people in finance and hosted a discussion on this subject: The Stupidest Thing You can Do With Your Money.

The anomaly

The panelists discussed the anomaly of Main Street investors “throwing away billions and billions of dollars” by purchasing actively managed funds (where the fund manager claims the ability to beat a risk adjusted benchmark, like the S&P 500 index).

Ken French, a professor of finance at Dartmouth College, observed this not something new. It has been going on for “the last 20 or 30 years.” Eugene Fama, a Nobel Laureate and professor of finance at the University of Chicago, had this to say about active managers: You’re charging people for stuff you can’t deliver. French summarized the views of the panelists, stating: “The notion that we can all get rich by trading actively just doesn’t make any sense whatsoever.”

The compelling data

In a seminal study, French and Fama found only the top 2 to 3 percent of active fund managers had enough skill to cover their costs. “Everybody else: down below that.” Perhaps because of this overwhelming evidence, Jack Bogle, the founder of Vanguard, noted that, in recent years, there’s been ”a trillion and a half flowing into index funds and a half a trillion flowing out of active funds, which is a $2 trillion shift in investor preferences. It is a revolution.”

Despite the “revolution”, the majority of Americans still buy expensive, actively managed funds, likely to underperform comparable, low management fee index funds.

Attempts at justification

Opponents of index based investing often argue the market isn’t perfectly efficient and skilled investors can exploit those inefficiencies. Barry Ritholtz, co-founder and CIO of Ritholtz Wealth Management, disagrees. He noted you have to be able to first find someone who can beat the market. That fund manager has to do so consistently, “year in year out.” And the returns need to be in excess of costs, fees, taxes and commissions. That’s a tall order.

The relative futility of engaging in this exercise has been known to the academic community since the late 1960’s. It’s taken this long for a minority of investors to catch up. Even now, index based investing accounts for only about 30 percent of investments.

A scathing rebuke

In a scathing rebuke of the active fund management industry (upon which most of the securities industry is based), Fama concludes that he “doesn’t know anybody for whom [active management] is worth it.” After analyzing more data “than almost anybody”, he concludes: “When you look at the world after costs — which is what people eat; they have to pay the cost of the people charging them — well, then, the whole industry looks pretty bad.”

You’re the butt of the joke

You’re paying a multiple of a low management fee index fund to purchase an actively managed fund. What are you getting for this additional cost? A fund statistically likely to underperform the index fund over the long term.

Why is the securities industry laughing at you? They’ve succeeded in transferring a portion of your money into their pocket by selling you an inferior product.

Listen to this podcast. Then fundamentally change the way you invest.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

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