In recent weeks the name of Neil Woodford has been added to the list of star fund managers who have crashed and burned. Woodford’s flagship Equity Income Fund is now closed to withdrawals as Woodford struggles to liquidate stocks to meet investor demands for cash back. Those demands are the result of significant underperformance by the fund over the last three years, which moved away from blue-chip dividend stocks into much riskier small start-ups and private companies.

In one regard this news is no news at all. Research shows that the majority of active fund managers (those aiming to achieve returns over and above the market) underperform the market in which they invest, and winning managers fail to maintain an edge over the long run. This compares to passive funds/managers who simply and cheaply replicate the index or market they track. Two arguments remain in favour of active managers  – they can outperform in niche markets and they should be able to outperform in bear markets by hoarding more cash – although evidence on both counts is sketchy.

As I’ve written before, the market is littered with active funds that promise to beat the market and charge accordingly high fees but only deliver market (ie, average or passive) performance at best. Their almost imperceptible degree of under/over-weighting cannot deliver the outperformance their fees should justify.

So what should you do?

Recognise any active/passive components in your investment. The decision to invest in a passive fund is a decision to abandon any attempt to beat the market. The decision to invest in a more expensive active fund is a decision to pay a premium in an attempt to beat the market. Remember, it’s easy to find a star manager or stock that has outperformed in the past but how do you know they will outperform in the future?

And what do we do?

We, like legendary investor Warren Buffett, are firm believers than index tracking (ie, passive management) is the simplest, cheapest way to achieve the market return. We therefore choose portfolios largely made up of a large core holding of renowned global passive funds in which active funds are added very selectively and for good reason.

In the words of Charles Ellis in his seminal book Winning the Loser’s Game, active investment management is a zero sum game before costs and a loser’s game after costs – and the only way the win the loser’s game is to not participate, ie, don’t set out to beat the market in the first place.

 

If you’re interested in this topic, see also my 5 Reasons to Never Ever Buy Individual Shares.