You might have heard about how much money actively managed funds make. Usually, it's from a friend who brags about how their broker made them a ton of money. They tell you how they made money even when the stock market is falling. And they offer you the chance to get in on the deal.
But how much money are they really making? They might make more money today. But what about the long-term?
What your friend might not realize is that most times, an actively managed fund is a bad investment. Between the high administrative expenses and the generally subpar performance when compared to an index fund, actively managed funds don't make as much money as they should.
There are many types of investment instruments you can buy. Here are a few of the most common:
- Stocks: These are shares in a company. You buy or sell them when you want through a broker.
- Bonds: These are fixed-income received from a loan made to an investor. They usually come from banks or the government. For example, if you buy a bond for $100, you are guaranteed a return of $110 six months later. The most famous type of bond is a U.S. Treasury Bond.
- Certificate of Deposit (CD): A CD is usually with a bank or other financial institution. Similar to a bond, if you leave your money with them for a period of time (like six months), they will give you a higher interest rate than your bank's savings account. If you try to get your money early, you will pay some sort of penalty.
In addition, to these investments, there are funds. A fund will buy a bunch of stocks, bonds, or other investment instruments. They will then sell shares of the fund to different investors. This allows an investor to own parts of many different investments without having to buy a ton of shares. The most famous types of funds are mutual funds (usually actively managed) and index funds (usually passively managed).
Funds have a manager. That manager decides when to buy or sell an individual investment. They also decide how much of an investment to buy. The manager's decision is important because their decisions control how well a fund performs.
Types of Funds
Generally, there are two types of funds:
Passively Managed Funds
These funds are generally “set it and forget it” type of funds. A manager buys a set of stocks or bonds and leaves them alone. The manager may buy or sell stocks or bonds every now and then to balance the portfolio. The idea behind these funds is to allow them to make money through long-term growth of the investments.
The most famous type of passively managed fund is index funds. These funds are meant to mirror the stock market. When the market goes up, index funds rise in value. When the market goes down, index funds will decline in value. Because the stock market rises over time, these funds make money over the long-term.
Actively Managed Funds
In these funds, the manager is constantly buying and selling stocks and bonds. They are trying to find the best mix that will make money. The goal is to provide the highest return possible. Often times, this means they will be buying and selling a lot of different stocks and bonds.
The goal of many actively managed funds is to “beat the market.” This means that the fund is trying to get returns that are higher than what an investor would get from an index fund. They also try to make money (or limit losses) when the stock market is down and most investments are losing value.
Why Actively Managed Funds Are Wasting Your Money
Fund managers are paid for how much work they do in managing a fund. This is called an expense ratio.
On an index fund, your expense ratio is low. Because index funds are meant to mimic the stock market, the mix of stocks doesn't change that much. This means that the fund manager does less work.
However, on an actively managed fund, the fund manager is doing a lot of work. They are picking stocks based on how much they think they will earn in the future. To do this, fund managers are constantly buying and selling individual stocks to create the best performing fund.
All this work costs money, and therefore the expense ratio is much higher.
How It All Breaks Down
As you might have guessed, actively managed funds cost you more because of their high expense ratio. A high expense ratio can add up. If you have a $1,000 investment and it has a 1% expense ratio, you will pay $10 a year. If the same investment has a 4% expense ratio, you will pay $40 a year.
Over time, these fees can really add up. If you have $500,000 invested, you will spend $20,000 in fees a year with a 4% expense ratio. With a 1% expense ratio, it's only $5,000.
In addition to losing $15,000 a year, you are losing the chance at making money off that $15,000. You can't invest that money into new shares of the fund. If you do, you won't get dividends or watch that money grow. You aren't just losing $15,000 this year. You are losing the chance to make thousands more from that money.
These high expense ratios are fine if an actively managed fund is making tons more money than an index fund. However, that usually isn't the case. Between 2010 and 2019, the long-term performance of most actively managed funds has been worse than index funds. Actively managed funds may beat an index fund for a year or two. But usually, they can't keep that up over a decade or more.
If an actively managed fund has higher expense ratios and makes less money over time than an index fund, why would you choose one?
Listen to Warren Buffet
If all of this doesn't convince you to avoid actively managed funds, consider the advice of Warren Buffet, one of America's most successful investors. Warren Buffet not only recommends index funds for most people but also emphasizes the importance of choosing funds with a low expense ratio.
Keep in mind who is pushing actively managed funds. Many times, it's from companies that want to make money off their fund managers. It also from people who use those fund managers and want to justify their choices.