Why actively managed funds perform worse over time compared to ETFs

When looking to diversify their portfolio, most investors turn to funds. Funds bundle multiple stocks in one and make it easy to spread money across multiple industries or countries. There are two options when looking to invest in funds: Actively managed funds and passive funds (ETFs). Actively managed funds tend to sound promising because of two reasons: Prestigious fund managers take care of your money and there is a potential for higher returns. However, in reality, active funds underperform passive funds (i.e. ETFs) over time. In this article, we will explore reasons why active funds underperform and why ETFs are the better investment option for most investors. I will present examples of underperforming active funds and guide you through the data. Read on to find out the key differences between active and passive funds and find out what is the best option for you!

Table of contents:

• Covering the basics of actively managed funds and index funds
• Looking back: The history of fund management and its performance
• Reasons for underperformance of actively managed funds
• Advantages of index funds (ETFs)
• Real life examples
• Conclusion

Covering the basics of actively managed funds and ETFs

Before we dive into the topic and discuss the advantages and disadvantages of actively managed vs. passive funds, I want to cover the basics.

What is an actively managed fund?

A fund is a collection of assets in this example being individual stocks. In an actively managed fund, the collection of individual stocks is handpicked by fund managers. They pick and choose stocks based on who they think will outperform. Their aim is to buy low and sell high, essentially trying to beat the market, and make a profit for their investors.

What is an ETF?

An ETF is also a collection of stocks, but instead of being handpicked by well-paid individuals, it mimics the performance of a financial market index. That underlying index (tracks the performance of certain companies to give an overall picture of how a specific part of the market is performing) could be the SMI (Swiss Market Index), German DAX, US S&P500. The portfolio of stocks is predetermined by the index. There is no interference by humans.

Find out more about ETFs my article here. 

Looking back: The history of fund management and its performance

To understand why passive funds are so popular nowadays it is helpful to look back. The first fund was established in the United States in 1924. The focus then was on actively managed funds that thrived on the expertise and market analysis of prestigious fund managers. ETFs were introduced much later in the 1970s. They focused on mimicking specific stock indices and didn’t need as much management, which led to lower fees. Over time the data showed that ETFs actually outperformed active funds. Adding this revelation to the fact that ETFs offered lower fees, diversification and consistent returns, actively managed funds didn’t look so promising anymore.

Reasons for underperformance of actively managed funds

Let’s dive into some of the reasons why actively managed funds underperform passively managed index funds. You would think that highly paid and well-trained fund managers would know what they are doing and be able to outperform automatized investing. Here is where you are wrong! And that is great news for you! Because it means that you don’t have to pay some individual a share of your profits. You can manage your portfolio (your collection of assets - invested or not - as part of your overall wealth) by yourself and make the same return in the long run.

That's of course if you stick to the basic rules of investing: Diversifying, knowing your time horizons (so you're heavily enough invested in stocks etc.), watching your fees (through ETFs), understanding when to take out risks from your assets as you're getting closer to needing your money liquid. Basically my own 4 rules of investing. 

Why do active funds underperform ETFs?

1. An actively managed fund needs a team of well educated fund managers. Those fund managers want to get paid a good salary. Therefore, an actively managed fund leads to higher expenses and fees on the investor side (you!) leading to diminishing overall returns for you (boohoo!).
2. The fund managers don’t get paid to sit around and do nothing. I believe your invested funds should be sitting within the invested fund and not be traded further - thus they shouldn’t be accumulating trading costs or managing costs, which an actively managed fund will do. In consequence, they tend to trade more and chase leads in hope of beating the market, which only increases trading and management costs.
3. Humans make mistakes. We are biased creatures thinking we can predict the future aka the stock market. Wow, are we wrong! History has shown that over and over again that we’re not able to predict the stock markets - no one is. As Benjamin Graham said in “The Intelligent Investor”: “You will be much more in control, if you realize how much you are not in control.” Thus, fund managers of active funds and their overconfidence in trying to predict the stock markets allow for bad decisions ending in lower performances.
4. It is difficult for fund managers to consistently outperform the market. They might have a good quarter making the right decisions (some would call it gambling), followed by a period of losses. Past performances of fund managers are never an indicator for future good performances. The psychology of Money written by Morgan Housel will give you even deeper insights to this.

Advantages of ETFs

Now to the fun part: The advantages of ETFs! Can you tell I am on “Team ETF”? 😉 ETFs are a great tool for investing beginners.

Here is why:

1. Because a passively managed fund (i.e. ETF) is mainly run by an algorithm and NOT by well-paid fund managers thus the ETF can offer investors a lower fees. Every ETF has a so-called “total expense ratio”, commonly referred to as TER. ETFs TER are lower than the TER of actively managed funds leading to more money in your pocket. i.e. lowest one I’ve ever seen was 0.05%, more commonly they are 0.12% - 0.20%. For actively managed funds fees can range anywhere from 1% to over 3%! 
2. ETFs “stupidly” follow a stock index (we love stupidity in this scenario!) They don’t sell and buy, which leads to lower trading costs. I take more of a Warren Buffet angle to investing and so should you. We’re not judged on our performance within one year (as fund managers are), thus we can invest and let the money rest - hence compound - for us. 
3. ETFs tend to be very well diversified and are thus less risky for investors. 
4. ETFs mirror the market allowing you to participate in the real-time performance of the market. Over time, this leads to consistent returns (we will get to that in a minute). There is no interference or trying to beat the market, which is the case with actively managed funds. 

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Real life examples

I have given you a list of reasons why active funds underperform index funds (ETFs). Let us have a look at some statistics to really bring this one home for you:

Source: New York Times article: Actively Managed Mutual Funds Consistently Fail to Beat Markets, Study Finds - The New York Times (nytimes.com)

“No actively managed stock {...} funds outperformed the market convincingly and regularly over the last five years.”

Wow!!  And: Over a 10 year span, 93.1% of actively-managed funds underperformed the comparison index. 93.1%!!

So why wouldn’t we choose passive funds?

• They are cheaper.
• They are diversified.
• They perform better.

Conclusion

With today’s technology at your fingertips, there is really no reason to add active funds to your portfolio. The data shows that active funds don’t beat the performance of passive funds and they diminish your return on investment through higher fees. It really is a lose-lose scenario for investors! Base your investment strategy around ETFs and leave the market to it. You will reap the benefits in the long run.