The question about whether to use active managers or passive managers when it comes to the stock and bond markets is one that has been discussed over and over on out class blog. A few weeks ago, I wrote about how some managers thought this was a good year for stock picking due to lower market correlation. Such theories have no statistical weight behind them; most active managers are outperformed by simple index funds each year, even before their higher management fee are considered. Despite the superior performance of passively managed funds, more people use active funds than passive funds. While I think the active versus passive question has been thoroughly settled, not as much discussion has taken place about why people use actively managed funds. This blog will provide a few theories for why people use actively managed funds rather than passively managed funds.
- Ignorance/Fear: The average American probably knows very little about the stock market and how it works. Sure, many people track the DJIA or S&P500 and perhaps know how the market is doing on aggregate, but that doesn’t really qualify as understanding the market. Thus, when they do want to invest their money into the stock market they feel like they have no other option than turning to the professionals for fear of losing everything that they invest. These professionals, probably seeking a management fee for themselves, point them to an actively managed fund.
- Clever Marketing: Investment firms certainly work to perpetuate the idea that investing in the stock market requires a professional. Such an idea is critically important for the health of their business. Every firm likes to tout how they beat their Lipper averages, which are a comparison to similar investments. Unfortunately, comparing an actively managed fund to other actively managed funds doesn’t tell an investor anything about how well they do relative to other types of investment vehicles. Especially with a market in 2013 where everyone brought in huge returns, brokers could easily advertise that their funds gained 25% in 2013, without their clients knowing they lost to the market by 7%
- People are willing to take the risk for higher return: Both Burton Mankiel and Professor Kimball recommended Vanguard Group for low cost index funds. In fact, Vanguard invented the index mutual fund! But even Vanguard offers actively managed funds in additional to passive index mutual funds. They admit that, “while Vanguard believes there’s a very persuasive argument for index investing, that argument doesn’t rule out well-executed active management at a reasonable price.” Some people may know that index funds generally outperform active funds, but they may be willing to take the risk that their active fund manager will hit it big one year.
- Not all markets are equally efficient: As a recent WSJ article suggests, some people believe that only some markets are efficient. Namely, markets with extremely high volumes, like large cap companies and bond markets are generally quite efficient. In recent years, even emerging markets have become quite efficient. But some investors question whether smaller markets like small cap stocks might still leave opportunities to find undervalued stocks. I personally believe that this theory may have a grain of truth behind it.
There is also one more important thing to consider: passive funds need active funds. If everyone just bought stock indices and then did nothing, the market wouldn’t react to economic changes, and then would hardly produce any returns at all. In order for a stock price to go up, there must be active managers willing to be a stock at a higher price than what the price is currently .