Our clients often ask us if active management is an effective financial strategy. We understand why many might be tempted to give it a shot (after all, Wall Street and the financial media promote active management relentlessly) but our answer is always the same – a resounding “No!”
Here are 4 reasons why active management wealth strategies fail.
1. Does Your Investment Manager Lack Commitment?
Did you know that actively managed funds are only 95% committed? On average, the cash portion of these funds ranges from 5% to 6%. In other words, when you invest in active funds, you don’t even have the option of being 100% invested in the market.
These cash balances are like having a money market fund inside your stock fund; they perform better when the market’s going down and worse when it’s going up. Worse still is that in the long run, the market goes up over time as shown in this graph of Stocks, T-Bonds, and T-Bills since 1928 and this graph of the Dow Jones Industrial Average since 1900.
In contrast, index funds keep an average of .5% in cash, 90% less than active funds. Cash equivalents between 5% and 6% represent a substantial drag on performance, and exacerbate the damage already done by the higher administrative costs associated with active management.
2. Are You Considering Hidden Wealth Management Fees and Costs?
Active management administrative fees average 1.4% (not counting hidden costs), as compared to the .2% cost of a money market fund. And speaking of added fees, attempts to beat the market also involve non-monetary costs, such as the time you’ll spend on research. If you take mutual fund selection seriously, expect to devote substantial time to the process. Considering the vast amount of information available on mutual funds, there’s really no limit to how much time you can spend sorting through the data in an attempt to determine the “best” funds.
But at what point do marginal costs equal marginal benefits? After all, time is our scarcest resource; you may know people that have enough money, but do you know anyone who has enough time?
Here’s a simple rule: If it puts extra demands on your time, it should be justified with extra benefits. Does the time-drain that results from active management add enough to your rate of return to justify its inclusion in your wealth management strategies?
3. Should an Unintelligible Strategy be in Your Comprehensive Financial Plan?
Let’s face it: Active management is inherently unintelligible. Ask how a fund manager attempts to beat the market and you’ll likely get an answer that makes no sense – if you get any answer at all.
Usually, active managers use stock picking or market timing, but how do they choose securities? How do they know when to sell? Psychic powers?
If something can’t be explained or defined logically, should you base your investment strategies – and your financial future – around it? Relying on active management is essentially faith-based investing – and while it’s fine to rely on faith when it comes to spiritual matters, it’s not the best idea when it comes to investment planning. Why the secrecy? Probably because it serves to perpetuate the myth of the expert market-timing investment professional.
In contrast, index funds are:
What you see is what you get.
4. Is Your Investment Professional Trading Lower Returns for Increased Risk?
Finally, actively managed funds match market averages, minus all of those fees and costs, of course. But this isn’t the whole problem; active management also brings a significantly higher degree of risk, due in large part to inadequate diversification. In contrast, by investing in index funds, you’re assured of capturing asset class rates of return – and greater financial peace of mind.