Why People Still Pay High Fees for Managed Funds Despite Outperforming Index Funds
Despite the widely accepted notion that index funds are the best and cheapest long-term investment strategy, people often choose to pay high fees for managed funds, even when only a small fraction of them outperform index funds. This article explores this paradox and the underlying reasons behind this behavior.
The Case for Index Funds
The definitive treatise on the merits of index funds over the long term is A Random Walk Down Wall Street by Burton G. Malkiel. [1] Released in 1973, the book debunked the myth that active management could consistently outperform the market. While the book was groundbreaking at the time, its arguments remain countercultural and challenging for investors to fully accept.
Index funds are designed to mimic a broad market index, thereby spreading risk and reducing the impact of investment biases such as loss aversion and confirmation bias. However, many investors find it hard to believe that sophisticated human allocation efforts are not worthwhile.
The Paradox of Outperforming Managed Funds
While the majority of managed funds fail to outperform index funds over the long term, there is always the chance that a few will do better. The numbers cited in support of managed funds being superior might seem exaggerated, but they are based on specific data sets and market conditions. Studies show that only a minority of funds consistently outperform the market over the long term, but this minority can be sufficient to reward investors who pick the right managed fund.
Moreover, the rationale for the existence of managed funds goes beyond the pursuit of superior returns. Capital markets serve the critical function of allocating capital to projects with the highest potential for return. This drives growth and efficiency in businesses, which over time leads to increased consumer satisfaction and economic prosperity. Thus, managed funds are essential in the symbiotic relationship between capital providers and recipients.
The Role of Financial Advisors
One of the primary reasons why people continue to pay high fees for managed funds is the money trail. Financial advisors and brokers often recommend actively managed funds rather than index funds because of the commission incentives. Advisors who manage active funds typically charge higher fees, whereas those who manage index funds tend to receive smaller or no commissions.
For instance, financial advisors who recommend Exchange Traded Funds (ETFs) often face lower commission rates compared to actively managed mutual funds. These cost differences translate directly into the fees that investors end up paying. As a result, the advisory business model is heavily influenced by the choice of investment products, which can lead to biased advice favoring funds that generate more commission.
Short-Term vs. Long-Term Performance
Many comparative studies on investment performance show that index funds outperform managed funds over longer periods, such as 25 years. However, this statistic is often ignored when investors are looking to make short-term gains. Managed funds, particularly those managed by experienced and capable fund managers, can generate better returns in the short term.
The issue arises because fund managers change frequently, and even the best managers can lose their edge over time. Therefore, choosing the right managed fund at the right time is crucial, but it requires continuous monitoring and management, which can be a complex and time-consuming task.
Some investors might make the mistake of selecting a few managed funds that look promising and sticking with them for the long term, hoping for consistent outperformance. However, this approach is risky because it ignores the possibility that the fund manager may lose their edge or be replaced by a less effective manager.
To mitigate these risks, investors should diversify their investments across multiple managed funds and actively monitor the performance of their portfolio over shorter periods. Regular rebalancing and re-evaluation of fund managers can help ensure that their investment strategy remains aligned with their long-term goals.
In conclusion, while index funds are generally the most cost-effective and reliable choice for most investors, there is still a place for managed funds in specific scenarios. The key is to understand the motivations behind the choices made by financial advisors and to practice careful, disciplined investment management.
[1] Malkiel, B. G. (1973). A Random Walk Down Wall Street. Princeton University Press.