Why Do Investors Keep Buying Actively Managed Funds?

Created on Monday, 09 June 2014 12:54

by Larry Swedroe

An overwhelming body of evidence shows that actively managed mutual funds underperform their appropriate risk-adjusted benchmarks. In addition, little to no evidence points to persistence of performance beyond the randomly expected, which means past performance isn't prologue.

That's the reason for one of the great puzzles in finance: Why do investors continue with such great persistence to buy actively managed funds that underperform their benchmarks?

Sebastian Muller and Martin Weber sought the answer to this puzzle in their study, "Financial Literacy and Mutual Fund Investments: Who Buys Actively Managed Funds?" Using data from an Internet survey conducted by a large German newspaper in May 2007, Muller and Weber constructed an objective financial literacy score to determine if there was a relationship between financial literacy -- the knowledge and understanding of financial matters -- and mutual fund investment behavior.

Does financial literacy explain this puzzling behavior? Here's a summary of their findings:

• Higher financial literacy is associated with socioeconomic and demographic characteristics: male, purchasing funds online, working in the financial sector, higher education levels, higher incomes, greater wealth and being middle aged -- all statistically significant at the 1 percent level.
• Financial literacy has a positive influence on both being aware of passive (index) funds and the likelihood of investing in low-cost passively managed fund alternatives.
• However, even the most sophisticated investors in their sample relied overwhelmingly on active funds.
• There was no relationship between management fees and financial literacy -- investors who believe they're better than average investors choose higher-cost funds.
• Future performance of the actively managed funds chosen by the most financially literate investors was economically and statistically below zero.

They concluded that while investors seem to be unaware of the risks and returns -- and especially the costs -- associated with actively managed funds, the lack of financial literacy among most mutual fund customers cannot completely explain the past growth in actively managed funds. They don't earn higher risk-adjusted returns.

The authors hypothesized that the all-too-human trait of overconfidence (in their ability to identify managers who would outperform in the future) explained the behavior of even the most financially literate investors.

This study's results are consistent with those found by professor John Haslem, who sought the answer to the same puzzle in his "Mutual Funds Win and Investors Lose," published in the Spring 2013 issue of Journal of Index Investing. Here are his main findings:

• A lack of investor financial sophistication provides a partial explanation. "In general, mutual fund investors appear unaware of mutual fund risks and returns, especially for actively managed funds." He adds, "Financial literacy is a strong predictor of investor knowledge of index mutual funds, and there is a significant positive relationship between literacy and likelihood of passive investing. Investors who buy funds with high past performance appear distracted and pay little attention to costs." They're guilty of chasing performance, or making the mistake of "recency."
• Little evidence shows that even financially sophisticated investors can choose active managers who will outperform their benchmarks after expenses. Even pension plans and hedge funds, with all of their resources, have failed to do so. Again, the explanation lies in overconfidence in our abilities. Sophisticated investors do appear to select superior managers, though it's the managers who benefit through higher pay, not the investors because the funds don't generate alpha (benchmark-beating returns).
• In the broker-sold mutual fund segment, actively managed funds underperform index funds. These funds have conflicts of interests that create weak incentives for identifying prudent choices. This allows the sellers to exploit ignorant or irrational retail investors. An agency conflict clearly exists between brokers and their investors.

On the other hand, an overwhelming body of evidence shows passive investing is the winning strategy. Vanguard's John Bogle isn't the only voice singing the praises of indexing and other low-cost, passively managed vehicles.

As I pointed out in "Think, Act, and Invest like Warren Buffett," the Oracle of Omaha recommends passive investing as the winning strategy: "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Seriously, costs matter."

And Yale's David Swensen had this to say on the subject: "Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice." That is, actively managed mutual funds charge their investors big fees while usually failing to deliver returns that beat the market.

This commentary originally appeared May 15 on CBSNews.com

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From the Sharpie of Carl Richards: A Great Source of Happiness

Created on Monday, 09 June 2014 12:52

Carl Richards, director of investor education for the BAM ALLIANCE, explains in his book The Behavior Gap on the difference between financial planning and life planning:

“I spend a lot of time talking and writing about worst-case scenarios: investors behaving badly, people losing their retirement, and so on.

But let’s not forget why we’re so focused on our financial security. We want to be happy, and to provide a good life for our loved ones.

This sketch is one of my favorites, even though it doesn’t say a word about money. When I get up in the morning, I try to remember what really makes me happy — great experiences with the people I love. When I use that goal as the baseline for my decision-making, it becomes a lot easier to focus on the things that really matter when it comes to investing: things like working hard, saving a lot, and behaving wisely.”

Happy in Retirement: The Power of Planning

Created on Monday, 09 June 2014 12:49

A recent Northwest Mutual study shows a connection between being a disciplined financial planner and being happy in retirement. The study shows that highly disciplined planners — those who know their goals, have detailed plans to meet them and don’t deviate from those plans — are more likely than non-planners to say they are “happy in retirement” (91 percent vs. 63 percent).

“Happiness can’t be bought, of course, but it can be planned for,” says Northwestern Mutual executive vice president Greg Oberland. “The links between discipline, financial security and happiness are quite distinct. There’s some powerful evidence to suggest that the small steps you take today can make a real difference tomorrow.”

To download the complete study, click here.