Never forget these two axioms:
Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.
Asset Classes, Part IIC
Mutual Funds/ETFs: Index Funds vs. Actively Managed Funds
You’ll hear actively managed funds or index funds in relation to usually only mutual funds, but in reality, it can be true for ETFs as well.
An actively managed fund is one in which a “fund manager” or an entire management team makes decisions about how to invest the fund’s money—stocks, bonds, how much, which ones, and when to buy/when to sell.
An index fund, by contrast, is passively managed and follows a market index. It does not have a manager or management team making any investment decisions. Whatever index it follows (e.g., Dow Jones, S&P 500, NASDAQ, etc.), it will mimic those exact same stocks in the exact same proportions exactly (I know, I know; redundant and repetitive) and precisely nothing else. (If you want to know about stock indexes/exchanges, slow your roll, as the kids say,…creepers…that’s the very next post…no peeking!).
Actively managed funds carry far more expense with it than index funds because the manager needs to be paid (a murky number, but the average when last checked out is just over $436,000/year with some over $20 million/year based on performance bonuses, but, hey, you know all about the Krebs cycle, so you’ve got that going for you), research staff/analysts, data analytic software which require updates, etc., etc.
For that reason, how much index funds charge you (the expense ratio, remember? Come on people. This is only going to get harder as we go and impossible if you can’t remember the simple stuff. You can do this. You went to med school and forced yourself way less important stuff than this. Other than the really important things in your life and your professional career, this is the most important thing you need to know and understand) is usually way less than an actively managed fund.
Actively managed funds often carry an expense ratio of 1% or greater whereas index funds are often less than 0.5%, even below 0.1%. When dealing with such small percentages, it may seem like there’s not much difference, but when dealing with many thousands of dollars over many years as you undoubtedly will in the future eventually, it makes a massive difference which will only be overcome by your actively managed fund doing much better than an index fund every year year after year. (Much more on this in a later post.)
Actively managed funds make it possible to beat the market especially in down years. As soon as the conversation on actively managed funds vs. index funds comes up, the actively managed fund groupies always invoke the name: Peter Lynch.
Ah, yes.
Peter.
Lynch.
The sainted Peter Lynch, the fund manager of all managers, ran Fidelity’s Magellan Fund, the world’s most famous actively managed fund (mostly because of Lynch), from 1977-1990. Under his management, the Magellan Fund outperformed the S&P 500 in 11 out of 13 years and had the best performance record of any mutual fund in the world over that time.
Not bad, huh?
At a time where the S&P 500 was at an absolutely sizzling 14.43% per year, the Magellan Fund from 1977-1990 averaged just over 29%/year.
In other words, if you do the math using the Rule of 72 and the Rule of 144, in those heady days of the 1980’s, you doubled your money in just five years by broadly investing in the S&P 500.
Pretty awesome!
But, if you had your money parked with Peter Lynch and the Fidelity Magellan Fund, you quadrupled your money just under five years.
Fidelity couldn’t have been more thrilled because when Lynch took over the Magellan Fund in 1977, the mutual fund had $18 million in total assets under management and by 1990, assets in the fund had increased 1,286 times to over $14 Billion!
(To be fair, Lynch didn’t post the best returns ever or not in the history of the Magellan Fund even. The best return for the Magellan Fund for one year was 116.08% (!) in 1965, and the best three year record was 68.32% annualized between 1965 and 1967.)
Lynch retired at the top of the financial world in 1990 at age 46 and never re-entered with a net worth reportedly hovering around $350 million in this past decade.
Also, not bad.
SR: “OK, Lynch did great for himself. Fidelity crushed it. What about the average guy like me who invested in the Magellan Fund?”
Physician, Wealth Thyself AKA PWT: If you invested only $10,000 in the Magellan Fund the day Peter Lynch took over and then sold the day he retired and not even more dime the whole time, you made $280,000 before taxes.
SR: Oh. Well, yeah, but who’s that lucky to go in and out with only Lynch?
PWT: 1.) It’s not Lynch’s fault what you do or don’t do. You asked about him; I gave you what you asked for. ***Never ask a question unless you want the answer.*** 2.) When you notice your exceptional fund manager that has beaten the market for over a decade is exiting the place, you should walk out too. It’s like defying gravity. Sooner or later, you have to start dropping. Get out while you can.
If you don’t know who your fund manager is and when they leave, then you’re
doing actively managed fund investing wrong.
WHETHER YOU REALIZE IT OR NOT, ONCE YOU INVEST IN AN
ACTIVELY MANAGED FUND, YOU HAVE DECIDED TO BECOME
AN ACTIVE, INVOLVED INVESTOR. SO DEAL WITH IT.
3.) Even if you fell completely asleep and were under a rock for the decade after
Lynch retired, you did well if you stayed in the Magellan Fund.
Year* MFR** S&P 500 Return
1990 (4.51%) (3.10%)
1991 41.03% 30.47%
1992 7.01% 7.62%
1993 24.66% 10.08%
1994 (1.81%) 1.32%
1995 36.82% 37.58%
1996 11.69% 22.96%
1997 26.59% 33.36%
1998 33.63% 28.58%
1999 24.05% 21.04%
*Duh
**Magellan Fund Return
Any returns in parentheses are negative. (Don’t ask me why. It’s an accounting thing.)
(Keep that in mind when you peruse your statements.)
As far as Lynch retiring in his 40’s with many millions and being celebrated worldwide… not bad work if you can perform for that level for that long…which no one else ever has thus why Lynch is a legend and bringing us to the problem of actively managed funds.
Statistically speaking, the vast majority of actively managed funds tend to “underperform,” or in other words, do worse than the market index.
The Magellan Fund (the example cited above) is bandied about so often because it’s the exception to the rule, not the rule…not even close actually.
Plus precisely no one guessed that the Magellan Fund would have done so well when Peter Lynch began as its manager. (Quite frankly, the Magellan Fund was an obscure fund that only became main stream a few years after it took off year after year.) We only know how well it did looking back.
Realize that every single time an actively managed fund sells a stock, the fund is hit with taxes and fees, which diminish the fund’s performance. Therefore, the more buying and selling (i.e., turnover) in an actively managed fund, the worse it will do unless the performance of the stocks it remains in outdoes the taxes and fees it has accumulated in the process…a chancy proposition.
Remember this also: You’ll pay a flat fee every year regardless of whether your fund does well or does poorly. (That’s true for index funds too though.) If the index offers a 7.25 percent return, and your index fund charges you 0.25%, then you’re at a 7% gain for the year. If your actively managed fund gives you an 8 percent return (Yay!) instead, but charges a 1.5 percent fee, then your gain that year is 6.5% (Booo).
Owning an actively managed fund means you’re dreaming of beating the market consistently or, at least, often enough and high enough that, net of fees (i.e., once you’ve subtracted out how much you’re paying each year as a privilege of owning the fund—you’ll see this phrase used a lot in articles, books, etc., so memorize what this means), you’re coming out ahead of an index fund.
Realize one more thing: If you own an index fund, you can just check in on your index (e.g., S&P 500, NSADAQ, Dow Jones) for the day, week, month, or even year and know exactly how well you did in that fund (minus a small expense ratio).
If you own an actively managed fund, how the market or a certain index or a certain stock or even a group of stocks performs tells you absolutely nothing about how your actively managed fund has done. In fact, believe it or not, the market or index could be up and your actively managed fund could actually be down because your genius fund manager (who only got the job because he’s the fund family’s CEO’s idiot nephew—bitter much, PWT?) is heavy into the only stocks that are actually down in an up market.
The only way to check on how your actively managed fund is doing is to check on the actual fund itself.
I think we’ve all had enough for one post.
I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.
Talk to you soon.