“Just How Useless Is the Asset-Management Industry?”

An interesting article on the Harvard Business Review blog, by Justin Fox, on a topic that most investors already have a strong feeling (or should I say “bias”?) about. It may not, therefore, change anyone’s mind — but the fascinating lead shows the active-management roots of passive-management legend Jack Bogle:

Writing under a pseudonym in the Financial Analysts Journal in 1960, mutual fund executive Jack Bogle made “The Case for Mutual Fund Management.” Bogle took the track records of four leading mutual funds going back to 1930 and compared them to the performance of the Dow Jones Industrials. Not only had the four beaten the Dow, handily, but during the period from 1950 through 1956, for which the brokerage Arthur Wiesenberger & Co. (the Lipper/Morningstar of its day) had calculated mutual fund volatility, all but one of them had fluctuated less than the Dow.

“[M]utual funds in general have met the test of time, and performed in keeping with their stated policies and goals,” Bogle concluded.

As tests go, Bogle’s had its flaws. The fact that four funds (they’re not named in the article, but Bogle once told me they were Massachusetts Investors Trust, Investors Incorporated — now Putnam Investors — State Street, and Wellington) that had survived since 1930 had performed well didn’t say anything about the performance of the many funds that didn’t survive, or the new ones that popped up in the 1950s. But it’s quite possible he was right that the tiny mutual fund industry of the 1930s, 1940s, and early 1950s had served its investors admirably.

By 1960, though, the mutual fund business was booming, and selling investors on high-cost, high-risk products called “performance funds.” Within a few years, researchers armed with more statistical skills (and these new things called computers) were examining the industry’s performance and finding it wanting. “[W]e find no evidence to support the belief that mutual fund managers can outguess the market,” Jack Treynor and Kay Mazuy of the consulting firm Arthur D. Little reported in the July-August 1966 HBR (sadly, we don’t have the article online). Multiple academic studies soon backed up that conclusion.

They’ve continued to back it up ever since. After costs, actively managed mutual funds trail the market. Yet while passively managed, much-lower-cost index funds have been available since 1976, when Bogle — who had a change of heart and, perhaps more to the point, had been ousted from his job running Wellington Management — launched the Vanguard 500 Index Fund, most investors still put most of their money in the hands of active managers.

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COMMENTS: 17


  1. Rob says:

    Let’s dig up this dead horse and beat it to death again. Mutual funds & etc exist for the same reason that all ‘financial management products’ exist – to enrich the asset managers, and give the mark, ie mean client, peace of mind. After all some white shoe Ivy League old money yachtclub boy is taking care of your money, they must know what they’re doing, right? Or the equivalent…a hard charging, up from the streets trader type / or pretty girl financial major type…whomever the intake officer, or in con parlance, the cornerman, sees you as susceptible to (sorry grammarians). I’ve had almost 50 years in money management, at first being worked over by these jackals, until, 30 years ago, I finally wised up enough to follow my own intuition. It’s a big scam; hucksters trying to separate one from their own assets. That’s the “management” part.

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    • James says:

      I disagree. While just about anything can & will be used by hucksters to separate the gullible from their money, the main point of mutual funds is convenience. Think about how much time & aggravation it would take a small* investor like me to try to do something as simple as an index fund strategy on my own. Then there’s the morass of keeping track of things like cost basis for the IRS… No, I for one am pretty darned glad there are mutual funds, and that all I have to do to invest is log on to Vanguard’s or TRP’s websites.

      *Or not so small: the few thousand I started with right after the ’89 crash is now well into 6 figures. And while I don’t have a yacht (not much use for one here in the high desert), I do keep horses and an airplane.

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      • Matt says:

        The point of the article is that actively managed mutual funds are inferior to passive indexes. Big difference between active and passive. The Vanguard 500 mentioned above is passive, charging only a 0.17% fee. Anything more than that, in the long term, is probably a ripoff.

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      • James says:

        Again, I disagree. Yes, there are a lot of actively-managed funds that don’t do as well as simple index funds, just as there are a lot of individual investors who make poor investment decisions. But there are, I think, some strategies that do outperform* the index funds over time, though those strategies do tend to be on the passive “buy and hold” end of the spectrum as well.

        *And if it is possible for funds/investors to consistently underperform the indices via a poor choice of strategy, why shouldn’t it likewise be possible – in fact, required – for other investors to outperform, since the index is merely the sum of all investment decisions?

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      • John Smith says:

        No. Because of trading costs.

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  2. Clancy says:

    “And Where Are The Customers’ Yachts?”

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  3. Pete says:

    The “Majority of funds under-perform the market” adage drives me nuts.

    In the first paragraph, you reference volatility, and kudos to you because risk is just as important to consider as return. Let me say it again: RISK IS IMPORTANT.

    If you looking at funds designed to be higher in volatility and return, they have higher risk. Some of them will give higher returns than the market, some will not.

    If you are looking at “Safe” funds, they will ALL under-perform the market in terms of direct return, but they will be much less volatile. You’d feel silly comparing a bond fun to the Dow Jones, yet you lump stable value funds in with everyone else?

    Overall, 80% of funds fail to give the same RETURNS as the market. However, a majority of funds have a different RISK LEVEL than the market – so it’s apples/oranges if you simply compare the returns.

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    • Vineet says:

      “The “Majority of funds under-perform the market” adage drives me nuts.”…I believe most academic studies determine the under or over performance on a risk-adjusted basis. So even if they include bond funds in the analysis, they are taking into account the risk (i.e. beta) of the bond fund and find that they under-perform even after adjusting for its risk.

      Regardless, most active mutual funds people tend to gravitate towards are the high-risk types: sector funds, international, emerging market funds, etc. These generally will have a higher risk than the market, so if anything, risk adjustment would make their underperformance even worse.

      What’s more, even if they do outperform on a risk-adjusted basis, they do not do so after fees. Certainly after fees, almost no mutual fund outperforms the market on a risk-adjusted basis. And even if one does, picking that person BEFORE the fact is next to impossible, and AFTER the fact, the effect will be short-term and short-lived.

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  4. Winston says:

    One reason that investors, especially ones with 401k’s invest in expensive active funds is that their employers don’t give them a choice. In my 401k, the only index fund option charges 70 basis points, comparable to many active funds. If we, as a society, want people making better financial choices, then reforming the 401k would be a very good place to start.

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    • dan says:

      Most 401k’s do offer index funds and there is a big push in the industry to auto enrolled and use target date funds. I have worked in the industry and would say that the reason people don’t save enough in their 401ks is because they don’t save enough and take loans and withdrawals too much. Those who consistantly save 10% or more and don’t dip into it actually save a lot of money. They might do better with low cost investments but this certainly isn’t the main thing preventing people from saving enough.

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  5. Steve Cebalt says:

    Most managed funds underperform their corresponding (risk-relative) benchmark index. Not only do they have to outperform the market, they have to outperform the market plus their fees. The law of large nunbers means that some managed funds will outperform their relevant benchmark index funds some of the time; but that is meaningless. Logically, if even one managed fund could consistently outperform the market and its fee basis year after year after year, there would only be one fund in the world; that one, because everyone would invest in it. Alas, it doesn’t exist. The wisdom of crowds — millions and millions of investors’ decisions being indexed in a fund — is tough to outperform by any single team of manager(s).

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    • Mike MacDonald says:

      I object to the use of the term “wisdom of crowds”. When the market heads for the cliffs the astute investment decision is to sell Lemming futures. That is not wisdom. Also the law of large numbers mathematically means that all statistics converge to Gaussian/normal with a large enough sample. 2008 proved otherwise when it comes to biological organisms.

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    • James says:

      Exactly! The “wisdom of crowds” is twofold. First, if lots of people are buying something, you buy it too, regardless of whether it’s overpriced, thus creating a bubble. Second, when the bubble breaks, and the market price of your investment has declined to less than what you paid for it, then you sell.

      If I had followed this so-called wisdom in 2008, I would be considerably poorer than I am today. Instead, I’ve followed a contrarian course for the last four years, putting every spare penny in the market, and have profited quite handsomely from it.

      Oh, and I didn’t follow the crowd’s wisdom in the housing market, either: no “upgrade” to McMansion, no home equity loan spent on lifestyle… Just a mortgage that was never even close to being underwater.

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  6. CR says:

    Financial types are good-for-nothing sharks, only out to enrich themselves on the blood, sweat, and tears of the hard working ignorant masses. As a matter of fact, so are doctors, dentists, mechanics, lawyers, and pretty much every other field that I could spend the time researching and learning. Perhaps Pol Pot was right? (All of you wearing glasses, line up on the left, please.)

    Sadly, the flaw in this premise lies in it’s simplicity. I can say with a fair degree of certainty that I could easily take up any off those professions – indeed, I still may. However, despite the fact that I could easily perform any repair on my car, I still go to a mechanic. (Yes, any…) I could also do my own taxes, write estate documents, perform minor surgeries, and a host of other tasks, but I don’t. Why? Because I prefer to consult with an expert. Mr. Dubner would surely agree that if the incentives were eliminated, the entire financial industry would disappear. Sorry, folks- that’s the truth. You cannot eliminate active management and suppose for even a moment that index funds will do squat.

    The truth is, financial folks do one very useful thing: they bolster the belief. Because, in the end, that’s all our monetary system is. Turns out the we all are a bunch of dumb herd animals. Well, unless you’re got “50 years” of experience dealing with those “jackals”. You sir, are special and unique. Let’s be honest, Even Bogle was little more than self serving.

    You know, I just remembered one profession filled with experts possessing endless credentials that I wouldn’t ever consider listening to: economists. Little better than a bad fortune teller or a good criminal profiler. I propose that we study which group performs worse: asset managers or economists.

    Cheers!

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    • Steve Cebalt says:

      Hi CR. You said, “As a matter of fact, so are doctors, dentists, mechanics, lawyers, and pretty much every other field that I could spend the time researching and learning.”

      You forgot prostitution. They provide a service you absolutly cannot do yourself independtly, on a straightforward fee-for-service basis.

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  7. Dave F. says:

    The real tragedy is that these brilliant financial workers can only make a living helping those who, for the most part, could manage their money on their own. People with severe money management issues (i.e. no money to invest and more bills than paychecks) have to manage finances alone.

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