Active Funds - The Worst Investment Ever?
There are two main ways in which you can buy stocks. This is to buy individual shares yourself or to pool your money with other people to buy a variety of shares known as funds. Funds offer a cheap way to invest in a highly diversified portfolio (lots of stocks from different sectors and locations around the world) with no stock market knowledge required.
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Investing in individual stocks is incredibly risky and is something that even professional investors with a vast amount of experience find extremely hard to pick “winning” stocks. The stock market is incredibly unpredictable and no one truly knows where the market is headed no matter how sure they are. For example, did anyone factor in the effect the coronavirus would have on the stock market before it hit? I think not.
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There are two types of funds you can invest in. You can invest in either mutual (active) funds or index (tracker) funds.
Index funds are designed to obtain the same rate of return as the market index (track the market index). It does this by buying all of the stocks in the index it’s tracking. Examples of major market indexes include the S&P 500 (US), the FTSE (UK) and the DAX (Germany).
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Mutual funds are actively managed by hedge fund managers who’s aim is to beat the market index. For example, if in 2019 the stock market rose by 8% on average, then hedge fund managers aim to achieve a rate of return greater than this.
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These hedge fund managers hand pick stocks that they believe will outperform the market. In addition, they will buy and sell stocks along the way that they believe best fits into their stock portfolio.
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The other main aim of hedge fund managers is to obtain a nice big salary. This is where your money will also be going if you were to invest in mutual funds.
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Why Actively Managed Funds Suck
One of the most successful investors of all time Warren Buffet placed a million dollar bet in 2008 that an S&P 500 index would outperform a hand-picked portfolio (active fund) of hedge funds over 10 years. He won by a country mile with hedge funds averaging a cumulative return of a mere 22%, whilst the S&P 500 index had cumulative returns of 85%. You can check out the article by clicking here.
Source: BRK 2016 Letter
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The actively managed funds have not been named publicly; the index fund is Vanguard’s S&P 500 Admiral fund. No mutual fund even came close to beating the S&P 500 index, despite all of the ‘experience’ and ‘analysis’ that went into picking the stocks for the various funds. How is this possible though?
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Reasons why Active Funds underperform Index Funds
1) Actively managed funds are riskier than index funds.
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This is because index funds eradicate the risk of:
– Picking stocks
– Hedge Fund Manager selection
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2) Active fund managers charge a much higher fee for managing mutual funds (in some cases outrageously high fees) when compared to index funds. This eats into the returns of the fund.
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“THE MIRACLE OF COMPOUNDING RETURNS IS OVERWHELMED BY THE TYRANNY OF COMPOUNDING COSTS” – John C. Bogle
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3) Active fund managers trade more often than an index fund. There are many costs associated with the buying and selling of shares. This also hampers the performance of mutual funds.
“CALLING SOMEONE WHO TRADES ACTIVELY IN THE MARKET AN INVESTOR IS LIKE CALLING SOMEONE WHO REPEATEDLY ENGAGES IN ONE-NIGHT STANDS A ROMANTIC.” – Warren Buffet
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In a nut shell that is all you really need to know about mutual funds. Let’s now move onto index funds and why they are truly superior.
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If you want more information as to why mutual funds are inferior to index funds, check out the video below.
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