Volume 1 • Issue3 • July/August 2013
SolidINVESTING
Lach Financial, LLC • Registered Investment Adviser
Patrick Lach, Ph.D., CFA, CFP®
Founder and Investment Advisor Representative
Of Mutual Funds and Wedding Receptions
In the previous two issues, I have discussed the differences
Suppose there are 100 people at an indoor-wedding reception.
between active and passive investors and the costs associated
Thirty of them are 5 feet tall, forty of them are 5.5 feet tall and thirty
with each strategy. Specifically, in the previous issue, I mentioned
of them are 6 feet tall. In other words, 30% are 5 feet tall, 40% of
that the average actively managed mutual fund has a weighted
them are 5.5 feet tall and 30% of them are 6 feet tall. The average
average expense ratio of 0.88% per year, while the average
height of a person at the reception is 5.5 feet tall. Now, suppose
passively managed mutual fund has a weighted average expense
10 people go outside to have a cigarette. Three of them are 5
ratio of 0.13% per year. Recall that an expense ratio is the
feet tall, four of them are 5.5 feet tall and three of them are 6 feet
percentage of assets under management that a mutual fund
tall. Notice that the people who are smoking have the exact same
manager charges investors to manage their money. I explained
characteristics as the 100 people at the reception – 30% of them
1
that if both actively and passively managed funds earned the
same average return, the average passive fund would earn 0.75%
more per year than the average active fund. Of course, no one
hires an active fund manager with the hopes of earning average
returns. Investors will often meticulously analyze a manger’s
background and track record in hopes of finding someone who will
earn a high return. However, before taking fees into account, the
average active investor will earn the same return as the average
Passive investors want to mimic the market, and do
so by removing a subset of the market that has the
same characteristics of the market. Active investors
passive investor.
purchase what is left of the market, in hopes of
The reason is simple, although it may seem complicated at first
beating the passive investors.
glance – anytime you take a population and remove a subset
from the population that has the exact same characteristics as
the population, the subset and the remainder of the population
are 5 feet tall, 40% of them are 5.5 feet tall and 30% of them are
will both have the exact same characteristics as the original
6 feet tall. The average height of the people smoking is 5.5 feet,
population. I know, I know, it sounds confusing; but let me offer an
which is the same height of the 100 people at the reception. What
example to explain what I mean.
about the 90 other people not smoking? Of these 90 people, 27 of
1. Fund weights are based on net assets as of July 31, 2012. Expense data is from
Morningstar, Inc.
them (30%) are 5 feet tall, 36 of them (40%) are 5.5 feet tall, and
27 of them (30%) are six feet tall; and the average height is still 5.5
feet tall.
In the previous example, we took a population (the 100 people
at the reception) and removed a subset (the 10 people smoking)
that had the exact same characteristics as the population. When
this happened, the remainder of the population (the 90 people at
the reception who were not smoking) also had the exact same
characteristics as the original population (the 100 people at the
reception).
This is what happens with passive and active investors. Passive
investors want to mimic the market, and do so by removing a subset
of the market that has the same characteristics of the market. Active
investors purchase what is left of the market, in hopes of beating
the passive investors. However, since passive investors purchase
a subset of that has the same characteristics as the market, what
is left over for active investors is also a subset that has the same
characteristics as the market. Therefore, before fees, the return
earned by passive mutual fund managers will be the same as the
return earned by active fund managers. However, recall that the
average passive fund manager have an annual expense ratio
that is 0.75% lower than that of the average active fund manager.
For this reason, the average passively managed mutual fund will
outperform the average actively managed mutual fund by 0.75%
per year. Don’t just take my word for it - this is the same argument
made by Nobel Prize winning economist William F. Sharpe in 1991
in his article, “The Arithmetic of Active Management.” 2
People who invest in actively managed mutual funds will often
concede the point made in this newsletter. Although some active
investors are aware that, on average, an active fund manager will
earn the same as a passive fund manager (before taking fees into
account), they are quick to point out that they do not want to find an
average active fund manager. They argue that all of the time they
…since passive investors purchase a
subset of that has the same characteristics
as the market, what is left over for active
investors is also a subset that has the same
characteristics as the market. However,
recall that the average passive fund
manager have an annual expense ratio that
is 0.75% lower than that of the average
active fund manager. For this reason, the
average passively managed mutual fund will
outperform the average actively managed
mutual fund by 0.75% per year.
spend researching a manager’s background, education and track
record will help uncover the next superstar mutual fund manager.
As I will show in the next issue, it can take several decades to
conclude, with a reasonable degree of confidence, that a manager’s
outperformance is the result of skill (rather than pure luck).
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2. Sharpe, William F. “The Arithmetic of Active Management.” Financial Analysts
Journal (1991): 7-9.