With a few exceptions, managed funds have lost the battle to indexes and exchange-traded funds.
Charles Ellis rocked the financial world recently when he suggested that actively managed mutual funds are being pushed into the periphery by passively managed funds.
“With rare exceptions, active management is no longer able to earn its keep,” the founder of Greenwich Associates consulting firm told the Wall Street Journal in a recent interview.
I checked with local investment and fund managers to see if they, too, saw Ellis’ latest article in Financial Analysts Journal as a wake-up call. Jacob Wolkowitz, investment manager at Accredited Investors in Edina, thought Ellis hit the nail on the head.
“Today nearly all stock pickers are smart and well-informed,” Wolkowitz said. “It’s difficult to distinguish yourself like you could 20 years ago. Funds are going away. It’s tough to get people to invest in actively managed funds.”
While Ellis suggested that the move to index funds may eventually force active fund managers into another line of work, it isn’t happening overnight. Actively managed funds still make up 71 percent of the total net assets in all mutual funds and ETFs. But the 29 percent of funds now in indexes and ETFs has grown 20 percent in just the last 5 years.
Investors are discovering not only that the vast majority of managed funds don’t exceed their index, but that they charge significantly higher fees than indexes to accomplish the same result. Only 3 percent of fund managers produce a return that covers their costs, which means that 97 percent of managers are only as good as a low-cost passive index fund, according to Eugene Fama, American economist and Nobel laureate in economics.
Fees used to be considered small potatoes (1 percent of assets) when returns were near 20 percent annually. But that 1 percent can bite off a huge chunk of retirement savings over time. An investor with $200,000 in an equity fund would pay $2,500 based on the average annual fee (1.25 percent) while the same amount in a stock market index fund (0.04 percent fee) could be as little as $80. After 30 years of fees and the power of compounding, the actively managed fund would put about $570,000 less in the pocket of the investor, assuming an 8 percent return in both funds before fees.
The good news for investors large and small is that fees are coming down. The average investor in an actively managed U.S. equity mutual fund paid 1.25 percent in expenses in 2013, down from 1.29 percent in 2012 and 1.35 percent in 2010. The peak was 1.52 percent in 2003, according to Morningstar.
Mark Henneman, lead manager of the Mairs & Power Growth Fund and vice president of St. Paul-based Mairs & Power funds, said that the pressure is on.
“Warren Buffett threw gas on the fire when he suggested earlier this year that his heirs should invest their inheritance in index funds,” Henneman said.
But he’s quick to point out that the fees for his company’s largest fund, the Growth Fund, are 0.68 percent, nearly half the market average. Part of the reason for the low fees, Henneman said, is because they don’t compensate financial advisers to sell their mutual funds. “It’s not in the best interest of their clients to support a big sales team,” he said.
Active fund managers are hardly giving up the ghost. While lower fees may attract or keep business, human nature will keep many fund managers in their current jobs.
“There will always be active fund managers out there,” said Grant Meyer, financial consultant with Fure Financial in Bloomington. “Passive management is boring. There aren’t any fun stories to tell at a party about how you made big bucks in an index fund.”
The Jim Cramers of the world will always believe that they can beat the S&P, even though very few of them do anymore. “It’s the greed in people believing that they can beat the standard,” said Meyer.
Some standards are easier to beat than others, said Wolkowitz. He agrees that indexes work best for domestic equities, but a fair number of actively managed international funds beat their indexes. And he doesn’t recommend using indexes for bonds. “Indexing doesn’t work for fixed income,” he said.
As Vanguard, the pinnacle of index funds, approaches $3 trillion in assets and ETF deposits near $2 trillion, investors might assume the number of new mutual funds is decreasing. That hasn’t happened yet. In 2013, 544 new funds were created and 271 ceased operations, according to Morningstar. Since 2000 the number of closed funds exceeded the number of new funds only in 2001, 2002 and 2009.
At the Carlson Funds Enterprise, which teaches finance students about portfolio management at the University of Minnesota Carlson School of Management, there continues to be a steady enrollment of students eager to be the next Peter Lynch. Jerry Caruso, managing director of the Enterprise, said that in recent years he’s been asking the board if the program should move to an ETF format, but so far they are holding firm.