A popular TV ad campaign features a talking baby who credits his financial success to the tools of a particular online brokerage firm (rhymes with "B-Trade"). This stock trading tyke is a prime example of an "active" investor - someone trying to identify the best securities to buy, when to buy them, and subsequently when to replace them with better choices. This is the approach taken by most mutual funds attempting to "beat the market" (albeit, generally using fewer diapers).
The alternative to this active approach is passive investing. The passive method eschews forecasting, stock picking or market timing, and instead focuses on minimizing costs to capture as much return as possible from a broad representation of the market.
Certainly active investing is more exciting, but is it the right approach?
Active investing involves higher costs. Trading, research and management expenses create a significant performance drag. Nobel Prize-winning economist William Sharpe explained this brilliantly in an article twenty years ago entitled "The Arithmetic of Active Management." Through simple mathematics, he demonstrated that the average actively managed dollar must under-perform the average passively invested dollar, due to higher costs. As Mr. Sharpe explained, this will hold true for any time period, and data appearing to refute this principle is "guilty of improper measurement."
Implicit in the active approach is an assumption that the future can somehow be better anticipated by a select few. Investments are impacted by many unknowable future events, whether it's the next uprising in the Middle East, the next terrorist attack or the next natural disaster. Long-term success arguably requires either consistently anticipating how future events will unfold, or simple luck.
Unfortunately, some things can be the result of sheer chance, including good investment performance, and it is difficult to differentiate skill from luck for a "winning" fund. (Think of all the office football pools that are won by someone picking games based on the prettiest uniform color...) Extensive research shows that there is little, if any, persistence in performance for top mutual funds. In other words, top funds don't tend to repeat - at least no more often than would be expected to occur by simple chance.
Certainly, some actively managed funds can (and will) beat the market, and therein lies the appeal of active investing. In fact, due to the number of participants, the top performers will always be actively managed funds. The difficulty lies in identifying these winners ahead of time. And unfortunately, the excess return of "winning" funds doesn't come close to making up for the large shortfall of the losing funds.
In any given time period, the majority of actively managed funds will fail to keep pace with a low-cost passive approach, and the longer the time frame, the worse things look for the active side. Our goal is to help you reach your goal, and in this situation, not being "active" is the best way to accomplish that.
