“Why, sometimes I’ve believed as many as six impossible things before breakfast.”
You’ve heard this a hundred times, I’m sure: Most actively managed mutual funds fail to beat the S&P 500. [i]
Certainly the battle between active and passive management of financial assets seems to be one not going well for the stock pickers, as passive funds attracted more than $500 billion in 2016, while active ones saw more than $340 billion in outflows.
The general assertion is that fund managers lack the skill necessary to outperform the benchmark — some formulation of “YOU SUCK AT YOUR JOB.” Which is a reasonable assumption, except that it makes very little sense that mutual fund companies would en masse turn their portfolios over to people who show so little aptitude.
Most people commenting on mutual fund performance haven’t actually ever run a fund. But I, after having launched and managed three funds with Motley Fool Funds, have the unique opportunity to look through both lenses. No, good Fool, the problem isn’t the portfolio managers — not all of them, anyway. The things that actually cause mutual fund underperformance are far more pernicious than mere incompetence.
In brief, there are four main factors — customers, consultants, regulators, and structure — that force mutual fund managers into conventional thinking, when the key to extraordinary market returns is unconventionality. It’s a basic disconnect, and it is really hard to resist.
The basic problem, distilled
At the core of mutual fund management is an agency conflict. Fund shareholders benefit, obviously, when the value of their shares goes up. Fund managers, on the other hand, make more money by growing assets under management, providing a powerful…