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Don’t some active mutual funds beat index funds?

Ramit Sethi

I got an email from an investment advisor named Ryan last week. He pointed out that some loaded funds (mutual funds that charge commissions) actually beat index funds. When I wrote All About Mutual Funds, I railed against loaded funds. Here’s how the conversation went.

From: Ryan

Sent: March 4, 2005

Subject: load vs no load

There are quite a few loaded funds that have beaten the market significantly.

He makes a good point that just because a fund has a load doesn’t necessarily make it bad.

From: Ramit Sethi [ramit@stanford.edu]

Sent: March 4, 2005

Hi Ryan,

Thanks for your email. You’re right, there are a lot of loaded funds that beat the market, but in my opinion, there are also a couple of downsides:

First, we are horrible at picking good stocks and funds. We’re even worse at knowing when to sell. The implication is that you can mitigate your risk by selecting no-load funds instead of paying for loaded funds that will get you similar (or often worse) returns. In other words, while there are some loaded funds that beat the market, it’s probabilistically very hard to pick which ones do that.

Second, it’s extraordinarily difficult for fund managers to beat the market year after year. Sure, they can do it for a year, maybe even 5, but if you look at the math, it becomes increasingly hard to beat it year after year. We can mitigate our risks by using index funds as part (not all) of our portfolio. If you have extreme confidence in some loaded mutual fund for whatever reason, maybe it’s a good idea to have some of it in your portfolio. But statistically, it’s likely that it won’t beat the market over a long period of time. If I were feeling more risk-seeking, I’d rather just take that money and invest it in a couple of stocks with positive outlooks.

-Ramit

From: Ryan

Sent: March 4, 2005

You make good points, I am an advisor and work with clients often times I use loaded funds and some times use index funds. I use loaded fund because I don’t get paid otherwise. The clients have no problems with this as often times they are very busy with their jobs, lives and time is a valuable commodity for these folks; the investment expense is the cost for the guidance and advice, as clients get older this become more and more valuable. (huge fragment sentence) God forbid they do something and make a bad decision that is irreversible.

I am of the view that with the right research and due diligence you can identify the shops that consistently outperform the market by using a # of quantitative measurements…including regression analysis, turnover ratio, cost among other measurements in addition to qualitative measurements (fund shop culture and quality). Perhaps for the average individual picking a fund is the equivalent of throwing a dart therefore statistically speaking there chances of picking an outperforming fund is slim, but for the diligent and studious person the odds improve dramatically as there are fund companies they do a better job on a consistent basis.

Here is something you can add to your website… if you have lump sums to invest and this will be a taxable investment the individual is even better off using an exchange traded fund. They can pick the lots to sell for tax purposes.

I keep half my assets in index etf’s and half in managed funds.

I agree with you about taking risk, pick a few good stocks with positive outlooks; concentration become necessary when you want to significantly outpace the market.

Have a good day.

Note that Ryan makes his money through broker commissions. I don’t hold it against him, but in my opinion, part of getting rich is learning how to manage your own investments so you don’t have to pay those fees.

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2 Comments

 
  1. Carlin

    “I use loaded fund because I don’t get paid otherwise.”

    One, he needs to work on how he presents himself through his communications, especially since he’s dealing with clients. Nothing says I don’t know what I’m doing like a poorly written email (even if you are the best at what you do, misspellings and poor grammar draw attention away from the purpose of what you are writing, and also reduce the reader’s trust that you know what you are doing)

    Second, that reaffirms a point that many people have made, especially Warren Buffet (the Greatest of all Time). Ryan isn’t recommending a loaded fund because it’s good for you. He’s recommending it because it’s good for him.
    Unfortunately in the investment advisory industry, their commissions aren’t tied to your returns. If they were, then Ryan wouldn’t be selling you load funds. He’d be trying to make you as much money as possible, because then he’d make more. Isn’t that a novel idea?

  2. Sean

    Ryan’s points are ridiculous. As a recent graduate with a BSBA in finance, it is a shame to hear that somebody is advising their clients to invest in loaded mutual funds. There is absolutely NO reason to be invested in front-loaded funds. In one aspect, Ryan is correct: some loaded mutual funds do beat index funds. My guess is probably about 5% of all available funds. In the case of the front-loaded fund, the investor is paying a front-load fee, then a management fee, and probably a 12 b-1 fee. If a client really wants to invest in an actively managed fund, they should at least invest in a no-load fund. It is a shame that Ryan has to make a living this way. In my opinion, Ryan should leave whatever parent company he is selling mutual funds for, start his own firm, give people hourly investment advice and charge a percentage of their assets under management, which would be just as valuable to him, and cheaper to his clients.