Good Luck Finding Investment Expertise

Most investment advisers don’t have the ability to select outperforming funds.

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We assume most professionals have expertise. That’s why we use them. We expect visits to our doctor to improve our health, not make it worse. When we get a new prescription from an optometrist, our vision should become clearer, and not more blurred. If I showed you peer-reviewed data indicating your health would improve, or your vision would be sharper, if you avoided doctors and optometrists, would you read it? If you were persuaded, would you follow the advice in these studies? I am confident most of you would.

There is persuasive, peer-reviewed data indicating that fund managers of actively managed funds (where the goal is to beat a designated benchmark, like to S&P 500 index) do not have the skill they claim. The best known of these studies was published by Eugene Fama, a professor of finance at the University of Chicago’s Booth School of Business, and Kenneth French, a professor of finance at Dartmouth College’s Tuck School of Business. The authors evaluated the performance of U.S. mutual funds that invest primarily in domestic stocks over a 22-year period. They found that 97 percent of them could not be expected to beat a risk-adjusted benchmark. Even if you somehow were able to identify these few managers in advance, the study found that, after fees and expenses, only a small percentage of fund managers had enough skill to cover their costs.

Another peer-reviewed study looked at 2,077 fund managers over 32 years and found that 99.4 percent of active fund managers showed no genuine stock-picking ability.

The ramifications for investors should be clear. They are paying over $10 billion annually in fees to managers of actively managed funds. Yet, after trading costs and management fees, as a group these funds trail their passive benchmarks by around 1 percent annually. Pay more, get less. What sense does this make?

Remarkably, this research has made little impact on most investors and the vast majority of 401(k) plan administrators. It’s particularly sad for participants in 401(k) plans because populating their investment options with actively managed funds lessens their ability to achieve market returns, which are theirs for the taking. Advisers vying for the opportunity to serve these plans often tout their ability to select outperforming actively managed funds. In my experience, most plan sponsors are not aware of the data showing the futility of this exercise. All they would have to do is ask these advisers to show them data demonstrating that their system has worked in the past. I have asked many times for information showing the date when advisers added funds to the investment options in a plan they advised and when they dropped those funds. With this information, it would be relatively simple to determine if their system worked. I have never received it. They know what it would show.

Good luck finding investment expertise. You are far more likely to find “good luck".

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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