There is an almost ever going debate about active mutual funds versus passive index funds. However, the more time that passes the more obvious it becomes that passive index funds rule as a portfolio option for investors. This is based on decades of academic study and real world data, and one of the best resources I’ve read in a while is linked to at the bottom of this post (beware, advanced graduate level reading).

The reason for superior passive fund performance is most often supported by the belief in the Efficient Market Hypothesis (EMH). Most people intuitively don’t like this idea as EMH (from weak-form to strong-form efficiency) states that the prices of all traded assets (stocks, bonds, etc.) are at every moment accurately priced because all risks and information relating to an asset is known to all involved in the market at the same time, and therefore, it is not possible to consistently outperform the market by using that information to signal inconsistent prices where you could make excess returns.

The support of EMH by real world data doesn’t seem to dissuade people from not believing it in. The false assumption is that EMH means that there is no manager skill involved and any excess return generated from owning an actively managed fund versus a passive index fund is purely luck. On the contrary (as explained in the paper linked below), there appears to be semi-strong efficiency along with significant fund manager skill. However, the skill of the manager does not produce enough alpha (excess return explained by the manager’s skill) to overcome his fees on a long-term consistent basis.

Most people believe when buying mutual funds they can chose a manager who will provide them with excess return greater than an index fund. They believe that 1) managers have skill, and 2) you as the investor can figure out what that skill is, and therefore, you can choose the best manager. However, the only variable that’s really available to determine and compare manager skill is based on past performance and past return. So, assuming a rational market (investors rationally invest money), investors will chase the funds that perform the best either every year or year-over-year. As the thinking go, “there are always a few mutual funds that do better than index funds, so why settle for market returns when you could get above market returns by choosing an active portfolio manager?”

The flaw in this thinking isn’t that managers don’t have skill (as that’s not what EMH means), but that 1) you can choose the winning managers based on past performance, and 2) that manager’s can maintain their excess risk adjusted return as invested money moves in and out of the fund, especially as successful funds draw more money over time. As quoted from the resource below based on their study (emphasis added), “investments with active managers do not outperform passive benchmarks [index funds] as a consequence of the competitiveness of the market for capital investment. If investors compete with each other for superior returns, they end up ensuring that none exist. A consequence of this insight is that the average skill level of all active managers cannot be inferred from their overall past performance…performance is not persistent precisely because investors chase performance and make full, rational, use of information about funds’ histories in doing so.” (p2-3).

What this says is that because you decide to chase performance and invest your money with those you believe to be the best funds with the best managers, and everyone else is doing the same based on past returns, any future excess return is diminished in part because of the new flow of money in to the fund. Managers’ skills are typically limited to the amount of funds under their control, and the better managers typically manage more money, but in doing so, they charge more to produce that excess return, and the fund also grows beyond their ability to manage the fund. So, even with a skilled manager, you will not find consistent returns, but that’s still assuming you actually have a clue what it means to be a skilled manager.

There are plenty of other reasons for investing in index funds instead of mutual funds including, but not limited to simplicity of investment, reduced risk of investment, and increased return of investment for a similar mutual fund of greater risk.

Mutual Fund Flows and Performance in Rational Markets