Link of the week: Why active fund management is a loser’s game

The last Savers meeting got me on a bit of an investing tear! And it’s been great, because everything I’ve been reading tells me that my current philosophy is ideal, based though it was on meager evidence initially.

I was absently reading the August issue of Kiplinger’s this morning while brushing my teeth, when I stumbled across an article that perfectly illustrated why index funds are better than actively managed portfolios. Every once in a while Kiplinger’s pauses in its stock-picking advice to look directly at the camera and say “But seriously, folks, don’t actually do that.” This article was one of those. And it’s why I still subscribe to Kiplinger’s even though I don’t believe I’ll ever be an active stock trader.

The article, “Fewer Trades, More Gains” by James K. Glassman, is so full of gems, I can’t say it any better myself, so I’ll just share a few of my favorites.

“Investors earn their money not in good times but in bad — when they muster the courage to hang on. The alternative, broadly called “trading,” is bad for your investment health.”

“Trading generates taxes, and taxes, combined with trading costs, erode long-term returns.”

According to researchers Brad Barber and Terrance Odean, “people who traded the most averaged returns that were 30% lower than those of the average customer — and 36% lower than the stock market itself.”

“The cost of trading is one facet of investing that you can control. Those costs apply not just to individual stocks but to mutual funds.”

“Over time, these fees mount up. Consider the Fidelity fund mentioned above. Its expense ratio, at 0.90%, is below average. But if you invest $10,000 and the fund returns an annualized 10% over the next decade, you will pay $1,444 in expenses, or 10.6% of your profits.”

HERE’s a horrifying tidbit, because I thought the expense ratio was the cumulative costs taken from your funds:

“Edelen and his colleagues also found that the costs of trading the securities in the average stock mutual fund (what they call “aggregate costs”) came to another 1.44%. These costs aren’t transparent. You don’t write a check for them each year, and they don’t appear on a line in a fund’s prospectus, as the expense ratio does; they show up only in a fund’s diminished return.”

“Can funds generate returns that overcome those high costs? An expensive BMW performs better than a low-priced Honda, so shouldn’t a high-cost fund deliver better returns than a low-cost one, even after taking all expenses into account? With regard to total costs, the Edelen study confirms what other research has shown on the matter of expense ratios: The luxury brands turn out to be clunkers. “We found a strong negative relation,” says the study, “between aggregate trading cost and fund return performance.””

“It’s a rare stock picker who consistently beats the market. So if nearly every fund manager generates gross returns that are close to the market averages, then the fund’s costs become the single most powerful determinant of its net returns — that is, of what you get to keep in your pocket.”

And here’s his closing volley — notice how he plugs index funds even though this entire article was about active trading and actively managed funds:

“Buy and hold is the best advice I can give to someone who buys individual stocks. The same advice applies to fund investors as well. Find a buy-and-hold manager — or buy an index fund — and hang on for the long term. You won’t regret it.”

He recommends some actively managed funds in the article, but after reading, I find it hard to believe anyone wouldn’t go for the cheapest, least active fund they could find. I know I have!

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