Benchmarked to Fail: Why Fund Managers Struggle to Outperform the Index

Introduction

Welcome to the wonderful world of investing, where the highs are high, the lows are low, and the jargon is enough to make your head spin.

Today, we're going to tackle a topic that's near and dear to many investors' hearts: the elusive pursuit of beating the market.

Enter the fund manager - that fancy-sounding entity who claims to have the magical ability to pick winning stocks and generate outsized returns. We've all heard the pitch: "Invest with us, and we'll help you beat the index!" Sounds great, right?

Well, hold onto your hats, folks, because we're about to debunk that myth faster than you can say "alpha." The truth is, fund managers aren't as impressive as they make themselves out to be, and they often fail to beat the index.

So buckle up, grab a cup of coffee, and let's dive into the world of fund managers and why they fail to beat the index.

The Myth of Fund Manager Superiority

Ah, the fund manager - that mythical creature who claims to possess the secret sauce for beating the market. It's no wonder we've all been duped into thinking they're financial geniuses. After all, tall claims and an air of authority makes us feel like we're in good hands.

But here's the thing: fund managers are just like the rest of us, except they get paid a lot more.

In fact, study after study has shown that the vast majority of fund managers fail to beat the index over the long run. Notably, as per the S&P Indices Versus Active Funds (SPIVA) 2022 India Scorecard as many as 87.5% of active fund managers underperformed the benchmark, and 89% of large-cap underperformed the benchmark in the long-run.

The case isn’t any different in other economies where none of the 2,132 mutual funds in the U.S. were able to outperform the index consistently. A similar situation can be observed in the United Kingdom where almost 70% of all active fund managers trailed behind passives.

How About Portfolio Management Services?

Portfolio management services may not necessarily be better than actively managed funds. They may still charge high fees and fail to beat the market in the long run. These services typically aim to pick individual stocks and create a portfolio that outperforms the market.

However, as per a study by Mint, less than half of portfolio managers beat their benchmark mutual funds.

So why do we keep falling for their slick marketing tactics?

Well, it's partly because we're wired to believe in expertise. We assume that someone who spends all day analyzing stocks must know something we don't. But the reality is, picking stocks is incredibly difficult, even for the so-called experts.

Plus, let's not forget that fund managers have a vested interest in making themselves look good. They get paid based on their performance, so it's in their best interest to hype up their successes and downplay their failures.

So, the next time you hear a fund manager boast about their track record, take it with a pinch of salt. They might be good at talking, but walking the walk is a different story.

Factors That Contribute to Fund Manager Underperformance

Now that we've dispelled the myth of fund manager superiority, let's take a closer look at why so many of them fail to beat the index.

First up: Fees and Expenses :

Fund managers charge a lot of money for their services, often in the form of management fees, performance fees, and other hidden costs. These fees eat away at your returns and make it even harder for fund managers to outperform the index. It's like trying to run a race with ankle weights on.

Eventually, even if the fund managers manage to match the index, net of fees investors will get lower returns than the benchmark.

Benchmark Hugging

Primarily, it is the large-cap funds, which invest in the biggest and most well-known companies, that tend to underperform. Notably, the companies they invest in are already well-researched and widely followed, which means there is less opportunity for a fund manager to gain an edge. Additionally, many large-cap funds simply mimic the stocks in the index, so there is little room for outperformance.

This is benchmark hugging. This leads to a portfolio that looks a lot like the index, which means the fund manager is essentially charging you a fee to buy a diversified portfolio of stocks you could have bought yourself.

Indistinguishable Tactics

Finally, we have limited information advantages. Fund managers are competing with thousands of other investors who also have access to the same information and tools. It's unlikely that any one fund manager has a significant information advantage over the rest of the market.

And we have the harsh reality that even if fund managers have access to the best information and tools, discretion doesn't always work in their favor. With so many factors at play in the stock market, even the most informed and experienced fund managers can't consistently outsmart the market.

All of these factors contribute to the underperformance of fund managers, and they're a good reminder that beating the market is harder than it looks.

But fear not, because there's a smarter way: ETFs.

The Case for Investing In ETFs

We've talked about why fund managers often fail to beat the market, but what's the alternative? Enter passive investing through Exchange-Traded Funds or ETFs.

If you're looking for a no-brainer way to invest, then passive investing through ETFs might just be your jam. Think of it as the lazy person's approach to investing, but in a good way! ETFs, or exchange-traded funds, are like a basket of stocks that you can buy with just one transaction. So, you're not putting all your eggs in one basket, but you're not juggling a dozen different baskets either.

As of the conclusion of 2021, the ETF industry worldwide comprised 9,877 products with 20,007 listings, holding assets worth $10.268 trillion. These offerings were provided by 608 providers and listed on 79 exchanges spanning across 62 countries. To read more check out this report by ETFGI.

When you invest in ETFs, the aim is to match the performance of a particular market index, rather than trying to outperform it – where the index funds or exchange-traded funds (ETFs) hold a basket of stocks that track a specific index.

A Respite From Costs

So why are ETFs a good option? For starters, it's much cheaper than actively managed funds. Since ETFs don't require the same level of expertise or trading activity as actively managed funds, they come with lower fees and expenses. This means you get to keep more of your returns, which can add up to a significant amount over time.

A good way to gauge the value proposition is tracking the expense ratio. Expense ratio is like the price tag on a fancy suit - it tells you how much you're paying for the fund's management and other expenses. In 2020, as per Investment Company Institute, actively managed equity mutual funds were sporting an average expense ratio of 0.70%, which is quite a bit more than the average expense ratio of 0.15% for passive equity index funds and ETFs. While in India the expense ratio for mutual funds can go as high as 2.5%, where ETFs typically average at 0.2% here.

Just As Diverse If Not More

ETF investing is also quite diversified. By investing in an index fund or ETF, you're essentially buying a piece of every stock in that index. This spreads your risk across tens or even hundreds of companies, which reduces your exposure to individual stock risk.

Staying With The Market

And perhaps most importantly, investing in ETFs has shown to deliver better long-term returns than actively managed funds. While most actively managed funds underperform their respective benchmarks over the long run, ETFs consistently match their benchmarks.

Of course, this isn't to say that ETFs are foolproof. Markets can still be volatile, and there's always the risk of losses. But if you're looking for a simple, low-cost, and effective way to invest, ETFs are definitely worth considering.

So the next time you're tempted to put your money in an actively managed fund, remember that the odds are against you. Instead, consider putting your money in a low-cost index fund or ETF and let the market do the heavy lifting. It might not be as glamorous as having a fancy fund manager, but your wallet will thank you in the long run.

Parting Thoughts

Of course, there's no one-size-fits-all solution when it comes to investing. It's important to consider your own goals, risk tolerance, and personal preferences when determining the best strategy for you. But before you entrust your money to an active fund manager, it's worth considering the viable alternatives.

Remember that investing is a long-term game, and it's easy to get caught up in short-term market fluctuations. But with discipline and perseverance, you can achieve your financial dreams and build a brighter future for yourself and your loved ones. So whether you choose to go the ETF route or not, keep your eyes on the prize and let the market work its magic.

After all, in the words of legendary investor Warren Buffett and his former boss (and teacher) Benjamin Graham, "in the short run, the market is a voting machine, but in the long run, it is a weighing machine."

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