Many investors are too fixated on picking the right stocks at the right time. Instead, they should be fixated on their total return after all fees.
Watch this video as Vincent Tey, Head of Advisory Team at Providend, shares why active management is a zero-sum game before cost, and the winners have to win at the expense of the losers.
1. What Are The Costs Involved In Investing In A Fund?
There are two kinds of fees – Transaction Fees and Annual Expense Fees. The transaction fee is the one-time fee that investors incur when investing in a fund. They are called sales charge, upfront fee and in some cases, it is the difference between the buying and selling price of the fund and we call them to bid and offer spread. There is no debate about it, the lower the cost, the better the returns.
Investors also should be careful of excessive switching fee if the account applies switching fee. One other form of the transaction fee that investors should be careful of is the redemption penalty in some investment structure. Be careful not to get into such structures.
For annual expense fee, it is the management fee, trading cost and also marketing expense of running a fund, also known as Total Expense Ratio (TER). Now as investors when we invest in a fund, our expectation is that with the fund managers’ education, skills and superior resources and time in monitoring the investment, they should consistently deliver better returns. In reality, however, research and historical data have shown that actively managed funds that charge high fees have consistently underperformed low-cost index funds.
2. What Are The Different Investment Approaches?
Essentially, we can approach investment in two ways – passive investment or active investment. Passive investment refers to the buy and holds approach where we buy into a passively managed fund or known as an index fund. Passive investors believe that the market is efficient. They have the confidence that the price reflects the collective knowledge of all the investors and it is hard to consistently find mispriced securities. Passively managed funds usually have a low annual expense of about 0.5% per annum or lower.
The active investment seeks to outperform the index through stock picking, market timing or sector rotation. They are called active funds. The fund managers can find any stock that is listed on the Singapore Stock Exchange and not limited to the STI component stocks. They believe that they can find mispricing securities, buy low and sell high. They also believe that they know which sector will do better or the market will go up or down in the future and profit from there. The annual expense of active funds is at about 2% or higher.
3. So, How Is The Performance Like For Each Investment Approach?
According to the data compiled by S&P Dow Jones Indices, the number of actively managed U.S. equity funds that beat the S&P 500 index over a period of ten years is less than 15%. Overwhelmingly, the majority of the funds failed to beat the index or the benchmark. Even in less efficient markets such as the Emerging Market, the number of actively managed Emerging Market funds in the U.S. that beat the S&P/IFCI index over a period of ten years is only around 18%.
Survivorship of the active funds is an even more worrying fact for investors beside underperformance. Over ten years, only 54.35% of the active funds that are benchmarked against the S&P 500 Index survived with the rest closing or merging with another fund. So, choosing an active fund that outperforms the index is one challenge. Choosing one that will still be in business for over ten years is another.
4. Why Do Most Active Funds Underperform?
One clear reason is the fee. Before cost, active investment is a zero-sum game. Active investors that earn above-market returns at the expense of other active investors. For example, let’s assume that there are only two fund managers in the markets – A and B. And let’s assume that the markets give a return of 10%. So, if Fund Manager A earns a return of 15%, that would mean Fund Manager B will only earn 5%.
After cost, however, active investment is a negative-sum game. Let’s assume that the running cost of both the funds is 2%. That would mean that Fund A will earn a net return of 13% and that of Fund B is only 3%. The average of these two funds is 8% which is 2% below the market return because of cost.
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