Look Beyond Cost for Active Management
Focus on low-cost equity mutual funds has increased dramatically in the past decade. While cost matters, mutual funds, much like other goods and services, should be evaluated based on what investors get for the price they pay. Indeed, few people start shopping for a car by asking, “What’s the cheapest car I can get?”
CLOSET INDEX EQUITY FUNDS* VS. TRULY ACTIVE EQUITY FUNDS∆ (Monthly group averages, annualized 1980 – 2016)
Source: AthenaInvest, Morningstar, Inc. | Notes: * Closet Index Equity Funds comprise all funds which carry an Athena Fund Diamond Rating of 1. ∆ Truly Active Equity Funds comprise all funds which carry an Athena Fund Diamond Rating of 5. Each month, the average cost and average subsequent monthly return are calculated for each group. The figures reported above represent the monthly averages annualized over a 10-year period. Complete information about Athena Fund Diamond Ratings can be found here: https://www.athenainvest.com/fund-diamond-ratings
Many active equity mutual funds are closet indexers, which are defined as funds which closely resemble a broad stock market index but charge an active management fee higher than an index fund. At the other end of the spectrum, truly active equity mutual funds pursue a well-defined investment strategy with consistency and conviction1. These funds tend to cost more but can deliver significant value over longer time periods. For an extra 0.4% in fees, truly active funds have delivered 2.2% greater returns per year versus closet index funds on average.
Active equity managers should be making investments that are different from the broad index. One simple way of determining whether a manager is doing this is by looking at the mutual fund’s r-squared to the broad index. R-squared is a statistic that ranges from 0 to 100 and is widely reported on financial websites. The higher the r-squared, the more the fund looks like the index; the lower the r-squared, the more different it is from the index. While this is not the only criteria that can be used for picking active managers, it can help avoid the costly mistake of overpaying for a portfolio that closely tracks an index and has a low probability of outperformance. When choosing funds, go passive or go truly active, but avoid the closet indexers.
1. A full discussion and definition of the terms “truly active,” “investment strategy,” “consistency” and “conviction” can be found here: https://www.athenainvest.com/strategy-summary
From the Behavioral Viewpoint
What is going on?
- Expenses and costs are tangible, accessible and easy to understand, while the long-term value of compounding and active management are abstract and harder to grasp. This creates an availability bias that causes us to focus on immediate costs which we can easily understand and control.
- Investors are overwhelmed by the complexity associated with investments and managing them. Substitution is a natural response, where we substitute a simpler problem or solution for a complex one. In this case, just looking for the lowest cost investment. The large asset managers and platforms are happy to provide low cost solutions and deliver average results to everyone.
- Marketing and distribution efforts, reinforced by the regulators recent focus on costs as something they can control, trigger our herding instincts and social validation. The government says it’s good for us, the advertisements say it’s good for us, everyone says it’s good for us. It must be good for us!
What can we do?
- Move beyond cost and performance alone when selecting active equity managers. Avoid closet indexers by selecting low r-squared funds.
- Build a growth portfolio with 5-8 different truly active funds that are each designed to perform in well in different ways and in various market conditions. Give managers a minimum of three to five years in order to reap the benefit of their skill.
- Work with a financial advisor as a trusted resource and coach. Gain from their experience, process, perspective and insights. Building wealth is a long-term endeavor that requires time and discipline.
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IMPORTANT INFORMATION AND DISCLOSURES
The information provided here is for general informational purposes only and should not be considered an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. It should not be assumed that recommendations of AthenaInvest made herein or in the future will be profitable or will equal the past performance records of any AthenaInvest investment strategy or product. There can be no assurance that future recommendations will achieve comparable results. The author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions. AthenaInvest disclaims any responsibility to update such views. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of AthenaInvest.
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