Active managers claim they can beat the market while taking less risk. If you’ve ever read anything on our blog before, you probably know where we stand on this (they can’t do it), but we’ll leave that alone for now. They may spend all their time talking about how they have done and what they think the market is going to do next, but beneath all the smoke and mirrors, they’re in the business of charging investors to manage their money, which means they are focused on both bringing in new assets and making sure they don’t lose assets. Like any other business, taking care of existing clients is more important than bringing in new one.
One of the foundations of finance is that investors are risk-averse. The pain of losing outweighs the pleasure of winning. For active managers, the damage of underperforming their benchmark is greater than the glory of beating it, so large, established funds—the ones with something to lose—want to basically hug their benchmark. They may not beat the benchmark by much, but they won’t lose by much either. In other words, people won’t sell the fund.
This creates a situation where a lot of the “active” funds are basically tweaked index funds that just happen to charge 1.5% of your money every year for the privilege of investing in them. It’s so common there’s even a name for it – closet indexing.
If you want to invest actively, then take a swing (although we don’t recommend it). Try to be the first to discover the next Apple. It’s simpler than ever to easily and cheaply build a well-diversified portfolio yourself. You don’t need to put your money in an active fund that charges 1% per year to get your exposure to the S&P 500 Index.
If you think you can beat the market (but seriously, I can’t stress enough how much we don’t recommend it), or if you think you can identify someone who can, don’t mess around with closet indexing. Make sure you don’t look anything like an index.
All that is if you assume that someone can actually guess what’s going to happen next. Unfortunately, it doesn’t work that way. As the great Yogi Berra said, “It’s tough to make predictions, especially about the future.”
Find out more about what does work in our ebook, “12 Principles of Intelligent Investors.”
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