87.98% of actively managed funds underperformed the S&P 500 over a 15-year span. So why do investors still seek to outperform the market despite data showing that the odds aren’t in their favor? Is it the desire to maximize returns in a short period of time, the willingness to take on more risk, or the fear of missing out? With actively managed funds being around for almost 50 years, the answer is not so clear as to why investors still seek to invest in these funds. Perhaps it is a combination of behavioral biases, the allure of potential high returns, and the hope that a particular fund manager might succeed where others have failed.
What Are Actively Managed Funds and Why Does It Matter?
The core goal of active management is that, with sufficient skill, one can consistently outperform the market or a given benchmark. The data used for this article is based on the S&P 500, a stock market index that tracks the performance of the 500 largest publicly traded companies in the United States. Actively managed funds aim to outperform the S&P 500 by having fund managers buy and sell various stocks to achieve a higher return on investment than the underlying benchmark.
What Are Passively Managed Funds and Why Does It Matter?
The goal of passive management is to mirror the performance of an underlying index. For example, an S&P 500 ETF is designed to trade exactly as the S&P 500 index does. Rather than trying to outperform the index, fund managers aim to track it as closely as possible.
Talking Performance
The image above represents the performance of actively managed funds over a 15-year period. The data comes from SPIVA, which tracks the performance of actively managed funds compared to their benchmark, in this case, the S&P 500. Only 12.02% of actively managed funds have been able to consistently outperform over 15 years. Warren Buffett, a renowned investor, and Cathie Wood, with her actively managed ETF ARKK, are well-known examples. Below is a graph illustrating the disparity in returns between active and passive management over the last three years, underscoring the challenge of sustaining success in active management.
Confronting Risk and Return
When considering why investors persist in actively managed funds despite the likelihood of underperformance over the long term, several factors come to mind. The common adage "high risk, high reward" often resonates in investment discussions, as everyone aims for the financial equivalent of hitting a home run. However, achieving such monumental success is rare. Even in baseball, where a batting average of .300 is considered quite good, the odds of hitting a home run are even lower.
Now, contemplate the balance between risk and reward in investing. While younger investors typically tolerate more risk in pursuit of higher returns, it's crucial to differentiate between reckless risk-taking and prudent investment strategies. Opting for actively managed funds solely based on their perceived higher risk can be misguided. Instead, a more strategic approach involves embracing calculated risks through passive investing, diversification, and thoughtful asset allocation. These methods provide a structured framework for managing risk while seeking to maximize long-term returns.
The Correlation With Day Traders
The North American Securities Administrators Association (NASAA) published an article stating that "70% of public traders will not only lose but will almost certainly lose everything they invest." Additionally, they found that "Only 11.5% of the sample evidenced the ability to conduct profitable short-term trading." Comparing this data to the findings recorded by SPIVA, it's remarkable how closely the percentage of successful traders mirrors that of unsuccessful ones. Indeed, the allure of FOMO, or the fear of missing out, often entices individuals more than the disciplined approach of playing the long game, which tends to be more sustainable over time.
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