Advocates of passive investing have lots of talking points, quite a few of which I think are horse-pucky. It appears that Morningstar may agree with me, although they phrased it in a much more conciliatory way. They looked at how investors actually selected mutual funds and had some interesting findings.
One of the common things spouted is that “80% of mutual fund managers underperform.” This is cited as evidence that you should just give up and buy an index fund, but the argument is bogus for at least two reasons. Here’s why:
1) It assumes that investors select funds by throwing darts. And that’s not what happens.
2) The logical syllogism is faulty. 80% of Americans can’t dunk either, but if I am in charge of the draft for an NBA team, does that mean I should give up on finding someone who can dunk? Of course not! By restricting my draft selections to, say, Division I college basketball players that are 6’8″ or greater, I significantly improve my chances of finding a whole lot of people who can dunk a basketball.
Morningstar weighs in on 1) as well:
And I think Morningstar user mrpcid hit the nail on the head posting one of the earliest comments on the Ferri video, saying that the flaw with some academic studies is that they act as if investors pick their actively managed funds at random from the entire pool of funds. But in reality, they use research from firms such as Morningstar to narrow the field, avoiding obviously horrible funds while focusing their efforts on what the military calls a target-rich environment. In this case, it is the small group of funds with numerous favorable characteristics that are not too hard to identify and which tend to endure, such as proven managers with a repeatable process, good stewardship, reasonable costs, and a manageable asset base.
If you assume investors could be picking from a target-rich environment, it turns out to be a game-changer. When Morningstar analyzed which funds investors owned the most of, a trend emerged:
That sounds great on paper, but what have investors done? Turns out, they know quality when they see it. About 80% of the total assets in active equity funds are held in funds that have beaten the market over the past 15 years. For sure, there’s been performance-chasing, but the flow data indicates that investors have done a decent job of avoiding the losers and buying the winners, perhaps switching from one winner to another.
[My emphasis.] Further, Morningstar points out that the active funds that have outperformed have done so by larger margins than the funds that have lagged. That means that if you put together a portfolio of several funds, even if one or two of them lagged a little bit, you might well make up the performance lag from the funds that outperformed.
There might be reasons to own index funds, but the “80% of active managers underperform” argument isn’t one of them.
