Regular readers of the Persuasion Blog know that the science of investing for long term gain (e.g. retirement) argues both theoretically and empirically for index investing (aka passive) versus managed investing (aka active). Unfortunately acquiring the science requires a fair amount of WATTage and, yes, My Dear Aunt Sally math, but not that much and not for that long. As an example, we’ve been tracking a charity bet between Warren Buffett, the greatest money manager of the past 50 years, against a boutique hedge fund that tests the gains of Buffett’s tactic (an index fund) versus the boutique’s tactic (hedging). Through seven years, Buffett is, to put it politely, slaughtering the hedge fund. Yet despite the science and Tell Me A Story example . . .
Passively managed equity funds are now about 17% of all mutual funds, compared with about 11% 10 years ago, according to Morningstar.
Well, at least index investing is growing if only at a Small Windowpane over the last decade, but still less than 20% of market share. Unless you have inside information – legal or otherwise – the long term tactic of buy and hold an index fund kills every other tactic. Yet, Other Guys persist in giving their money to active managers who can’t beat the index and charge higher fees for the active management. There’s got to be a lot of persuasion going on to explain this.
Begin with Fidelity and its CEO.
Executives in charge of the firm’s U.S. stock funds said Ms. Johnson has no plans to make changes to the division, believing that the strong performance of the funds, about 80% of which the company says are beating their benchmark, eventually will woo investors back. Other Fidelity executives share her view.
Fidelity holds over $2 trillion in assets under management (active or passive) and is an 800 pound gorilla in the investment world although with inflation we should be talking a 1000 pound gorilla. Fidelity is huge, old, and respected. And, from top to bottom they know their actively managed funds can beat the benchmark (some kind of index) 80% of the time.
Science says that 80% estimate is impossible. Impossible. No group of funds hits that 80% mark consistently over time. It does not happen and you can dial up your WATTage and get your favorite calculator (the new Apple watch!) to prove it.
But at least 83% of investor Other Guys won’t do this and that’s the secret to the persuasive success of Fidelity and other companies that provide active management with higher fees and lower performance than a stupid index fund. We return to persuasion’s best friend: Other Guys hate to spend their WATTage. They prefer to default to the Peripheral Route and make shortcut choices and decisions and actions based on Cues. Consider.
Comparison: When others are doing it, you should, too. Hey, when 83% of other investors are going active, guess where you are going?
Liking: Active managers provide personal contact whether by phone or in the office. They compliment you on your wisdom to save and invest. They praise you for your conscientiousness and love of your family.
Authority: Active managers often have MBA degrees from elite schools plus a lot of sheepskins with other acronyms indicating specialized training and certification.
Reciprocity: Active managers give you their time and expertise and don’t directly bill you for it, so you never pay anything to get into the active fund or receive the active management. You then reciprocate with regular investments into the fund. Later, the fees are taken out of the returns which you don’t carefully count and don’t compare to other funds, like indexes which have much lower fees.
Commitment/Consistency: If they can get you in an active fund the first time, you’ve made that first step which commits you to a system of thought and action that will drive future consistency, even in the face of contradictory information as Warren Buffett drives the Protégé Hedge fund into the ground like a tent peg. The inertia of persuasion takes hold.
Scarcity: Sometimes active funds get so big that they close them to new accounts. Sometimes active funds have a limited supply of shares in new opportunities (Facebook IPO). Act now! Supplies are limited!
The success of the actively managed fund for long term investing begins with that Low WATT Other Guy. You see another example of how human nature hates to use up valuable thinking resources and persistently chooses a course of action that costs more money to obtain and produces less money over the long haul. Worse still, the required thinking here is not rocket science, despite the math voodoo Wall Street quants invent. Count how much you put in, then count how much you accumulate. Compare it to the outcome from an index fund.
You will always find a Small advantage every year with index investing which accumulates with the Joys of Compounding so that your Small gains grow geometrically, not arithmetically. After 30 years, you may double your gains with an index fund over the typical actively managed fund. Here’s a table to illustrate and yes, it has numbers (click to enlarge). Dial up for two minutes.
The top row shows different rates of annual return. Each row is one year. Look at the bottom of the table and compare how much more you earn with just a 1% or 2% advantage. This is just the basic and irrefutable math of compounding a rate of return over time. Empirically, the advantage for index investing is even larger.
In a piece for the January/February issue of the Financial Analysts Journal, Bogle made a devastating case for passive investing (i.e. investing in an index fund). He argues that even if the active fund manager is able to match the performance of an index fund tracking something like the S&P 500, the investor would still get crushed by fees.
In his study, over a 40-year period the passive fund investor would pocket an average annual return of 6.6% versus the active fund manager who would pocket just 3.9% (see chart above).
Here’s the chart.
The chart assumes that US business averaged a real 7% increase each year, then compares how much of that gain you would capture with either indexing or active management. If you are willing to keep your WATTage dial up, you can read the math (pdf). The analysis concludes:
Compared with costly actively managed funds, over time, low-cost index funds create extra wealth of 65% for retirement plan investors.
So, if Other Guys gave their money to an active manager and after 30 or 40 years they might have $1 million earned which would mean that the index Other Guy would have $1,650,000 earned. But, you’ve got to go High WATT and think about this all by yourself and Other Guys hate doing that, especially with their money.
This remains one of the great illustrations of human nature and our vulnerability to persuasion. Because we hate to go High WATT and hate math, we will surf on Cues even though it costs us hundreds of thousands of dollars in lost earnings simply because we will not have that Long Conversation in the Head with numbers.
You can never go broke underestimating the WATTage of Other Guys!