Live

Watch CBSN Live

Why Do Actively Managed Funds Remain So Popular?

It's no secret that actively managed funds have traditionally lagged their passively managed peers. Despite that, actively managed funds retain the lion's share of equity fund assets, a fact that has been the source of no small amount of head scratching among academics and investment experts over the years.

The traditional explanation for this seeming conundrum has been, in a word, ignorance. That is, most experts believe that actively managed funds remain a popular choice simply because the average investor doesn't know any better; they're unaware of the long odds against their success.

In a new paper, two professors challenge that hypothesis, and argue that the popularity of actively managed funds isn't a function of investor ignorance, but rather reflects a shrewd assessment by investors of the likelihood of actively managed funds' success over the long term.

To prove their hypothesis, the professors built a model which seems to show that investors in actively managed funds increase or decrease their holdings in response to what they expect those funds to earn in the future, relative to their benchmarks. These investors, according to the theory, recognize that as the assets in actively managed funds increase, the odds for outperformance decrease -- more assets chasing few opportunities to add value lowers the expected future performance of active fund managers.

Thus, after a period of underperformance, investors will pull some of their money out of actively managed funds -- but not all. Why? Because, according to this theory, the investor will recognize that his or her fellow investors will also be lowering their allocation to actively managed funds, which increases the likelihood of active management's success going forward. Therefore, the typical investor will keep some assets in actively managed funds in the hopes of earning a share of this expected future outperformance.

It's an interesting theory, and one that would certainly explain the continued faith in active management, but I don't buy it for a few reasons.

First, the success of passively managed index funds depends not, as the professors seem to believe, on how efficient markets are. Regardless of whether there are ten actively managed funds chasing after mis-priced stocks or 10,000 doing so, the average investor will earn the market's return, minus the costs they incur. And because index funds typically charge expenses that are a fraction of those of actively managed funds, they inevitably provide higher net returns than their actively managed counterparts, efficient market or no. In an inefficient market, the winning funds might outperform by a higher margin, but the other side of that equation dictates that the inevitable losers will likewise underperform by a larger margin. The low-cost index investor, meanwhile, will still outperform the majority of his or her peers.

So the notion that the average investor is "smart enough" to recognize the effect of a larger asset base in actively managed funds, but at the same time not wise enough to recognize the mathematics described above is a bit of a push, in my opinion.

Secondly, as one who's interacted with more than my share of investors over the years, I strongly believe that investor faith in active management isn't the result of the sort of dispassionate analysis the professors describe, but rather represents a fundamental misunderstanding of how investing works.

The problem is that the path to success in personal investing is unlike that pursued in almost any other field. Unlike most walks of life, there is no expected benefit for working harder, doing more homework, and "paying up" for expertise in the investment world. While those traits might lead you to success in finding an expert surgeon or carpenter, they'll almost inevitably detract from the returns you earn in the markets.

Instead, the path to investment success is almost completely counterintuitive: opting out of the chase for outperformance and accepting "average" performance will result in higher returns relative to your peers. Further, investor recognition of this is typically hard-won, and the light goes on only after they've spent years following the mutual fund industry's traditional model of buy and hope.

So the fact that actively managed funds remain so large in comparison to index funds isn't, in my opinion, a reflection of investor ignorance, per se, but of the fact that so many investors -- quite logically -- are approaching personal investing with the same mindset that is successful so many other aspects of their lives -- a belief that if you're smart enough and work hard enough, results will follow. The fact that hundreds of millions of dollars are spent by the participants in the mutual fund industry encouraging this misconception doesn't hurt, of course.

Encouragingly, the light is going on for an ever-increasing number of investors, evidenced by the fact that since 2006, actively managed funds have seen more than $160 billion in net cash outflow, while index funds have seen nearly $600 billion of net inflow. As a result, indexing's share of all equity fund assets has risen from 16 percent to 25 percent during that period.

Will we ever get to a point in which the lion's share of equity assets are invested in broad market index funds, held by investors who have adopted a buy-and-hold mentality? Perhaps not, but the fact of the matter is that we're a lot closer to that point in 2011 than anyone had a right to hope for just a decade ago, as a recognition of the benefits of an indexed approach continues to slowly supplant the mutual fund industry's conventional wisdom, bit by bit.

View CBS News In
CBS News App Open
Chrome Safari Continue
Be the first to know
Get browser notifications for breaking news, live events, and exclusive reporting.