An active fund manager selects the companies and sectors they believe are going to outperform a common index. For example, an active manager may benchmark their performance against the ASX 200. This index reflects the performance of the 200 hundred biggest companies in Australia.
Who wouldn’t people want all their investments going towards companies that outperform index management?
The issue with this, is that outperformance is highly unlikely. For every manager that outperforms, someone must be on the losing side of the trade.
So yes, your individual manager may outperform every now and then, but chances are you are going to lose out in the long run.
The reason for this is fairly simple. Most active fund managers charge a higher fee. So not only does your manager need to outperform, they need to outperform by more than the additional fee charged.
An example. A super balance of $500,000 is divvied up between 10 active managers who each get 50,000 to invest in the 30-40 companies that they believe will outperform. These managers charge a fee 1% higher than an index fund tracking the ASX 200.
Using the above figure, if the ASX 200 gained a return of 10%, you’d need a return of more than 11% just to get back to square.
Another advantage of index management is that you will automatically be very diversified. For example, the largest 200 Australian companies hold about 90% of the market capitalisation of all the companies (roughly 1500) in Australia.
So, what should you choose?
We believe that the time and effort put into searching for the outperformers can be better spent elsewhere. For example, minimising tax, making sure you are saving enough each fortnight, and things you can control.
If you have the ability see into the future and pick the active managers that are going to generate that larger return, then go for it.
If not, save yourself money on fees and stick with index management.
Written by Ali Hogue.
Dallas Davison, Michael Hogue and Ali Hogue.