This is where a salesperson tries scaring you—suggesting that active managers have the ability to quickly sell stock market assets before the markets drop, saving your mutual fund assets from falling too far during a crash. And then, when the markets are looking safer (or so the pitch goes), a mutual fund manager will then buy stocks again, allowing you to ride the wave of profits back as the stock market recovers.
There are problems with this smoke screen. First, nobody should have all of his or her investments in a single stock market index fund. They should own a global representation of stocks and a bond market index for added stability. Bonds are loans investors make to governments or corporations in exchange for a guaranteed rate of interest.) If the global stock markets dropped by 30 percent in a given year, a diversified portfolio of stock and bond market indexes wouldn't do the same.
Have some fun with self‐proclaimed financial soothsayers. Ask which calendar year in recent memory saw the biggest stock market decline. They should say 2008. Ask them if most actively managed funds beat the total stock market index during 2008. If they say “yes,” you've exposed your Pinocchios.
SPIVA published detailed proof. In 2008, US stocks plunged 37 percent. But despite that horrible year, the US stock index beat 64.23 percent of actively managed US stock market funds.13
Global stocks fell 40.11 percent in 2008. Yet the global stock market index still beat 59.83 percent of actively managed global stock market funds during that calendar year.14
Warren Buffett wagered a $1 million bet in 2008, unveiling more damning evidence against expensive money management. A few years previously, the great investor claimed nobody could handpick a group of hedge funds that would outperform the US stock market index over the following 10 years.
Hedge funds are like actively managed mutual funds for the Gucci, Prada, and Rolex crowd. To invest in a hedge fund, you must be an accredited investor—somebody with a huge salary or net worth. Hedge fund managers market themselves as the best professional investors in the industry. They certainly have plenty of flexibility. Hedge funds (according to marketing lore) make money during both rising and falling markets. Managers can invest in any asset class they wish; they can even bet against the stock market. Doing so is called “shorting the market,” where fund managers bet that the markets will fall, and then collect on those bets if they're right.
Buffett, however, doesn't believe people can predict such stock market movements, charge high fees to do so, and make investors money.
Hedge Fund Money Spanked for Its Con
Grabbing Warren Buffett's gauntlet in 2008, New York asset management firm Protégé Partners bet history's greatest investor that five handpicked hedge funds would beat the S&P 500 index, a large US stock index, over the following 10 years. Protégé Partners selected five hedge funds with index‐beating track records (each was actually a fund that contained winning hedge funds within it). But historical results are rarely repeated in the future.
The bet began in 2008. Stocks crashed that year, so it should have been a great year for hedge funds. If the fund managers could have predicted the crash, they would have pulled far ahead. But that didn't happen. In the years that followed, the S&P 500 ran like an Olympic Kenyan marathoner from a pack of pudgy men.
By January 2018, Buffett had won. Vanguard's S&P 500 Index gained 98 percent. The hedge funds were up just 24 percent. In fact, none of the funds of hedge funds kept pace with the S&P 500.15
If you've read Simon Lack's book, The Hedge Fund Mirage, these results won't surprise you. He says hedge funds produce horrible returns. Lack reveals that a portfolio balanced between a US stock index and a US bond index would have beaten the typical hedge fund in 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, and 2011.16 After his book was published, hedge funds continued to underperform the balanced stock and bond index in 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 and 2020. In other words, a balanced stock market index beat the Masters of the Universe for 18 straight years…and counting.17
In fact, the hedge fund managers' shortfall was so poor that the managers could have worked for free (not charging their usual 2 percent per year plus 20 percent of any profits) and a balanced US index fund would have still given them a beating.
The global stock market index (which includes US and international stocks) also beat hedge funds to a pulp. Consider the hedge fund industry's failure to beat portfolios of market indexes. If they can't do it, what chance does your financial advisor have? If your advisor has Olympian persistence, you might hear this:
You can't beat the market with an index fund. An index fund will give you just an average return. Why saddle yourself with mediocrity when we have teams of people to select the best funds for you?
If the average mutual fund had no costs associated with it, then the salesperson would be right. A total stock market index fund's return would be pretty close to average. In the long term, roughly half of the world's actively managed funds would beat the world stock market index, and roughly half of the world's funds would be beaten by it. But for that to happen you would have to live in a fantasy world where the world's bankers, money managers, and financial planners all worked for nothing—and their firms would have to be charitable foundations.
If your advisor's skin is thicker than a crocodile's, you might hear this next:
I can show you plenty of mutual funds that have beaten the indexes. We'd buy you only the very best funds.
The SPIVA Persistence Scorecard proves that selecting mutual funds based on high‐performance track records is naïve. Twice a year, the firm looks at the top performing actively managed funds: those that are among top 25 percent of performers. Then they wait a couple of years and determine what percentage of those winning funds remains among the top 25 percent of performers. Typically, about 75 percent of those “top‐performing” fall from grace after just two years.18
Neither you nor your advisor will be able to pick the funds that will win over the next year or decade.
If the salesperson's tenacity is tougher than a foot wart, you'll get this as the next response:
I'm a professional. I can bounce your money around from fund to fund, taking advantage of global economic swings and hot fund manager streaks, and easily beat a portfolio of diversified indexes.
Sadly, many investors fall victim to their advisor's overconfidence. Instead of building diversified accounts of index funds, they build portfolios with actively managed funds that are on a hot streak. But the results typically lead to underperformance or disaster.
Why Most Investors Underperform Their Funds
If you're countering your advisor's market‐beating claims with proof, he or she might start to panic. When the advisor's desperation peaks, you might hear this:
We use professional guidance to determine which economic sectors look most promising. With help from our professionals, we can beat a portfolio of index funds.
Colleges hire some of the brightest finance minds in the world to manage their endowment funds. They look at current trends, interest rates, corporate earnings and the economic landscape. But most of them lose to diversified portfolios of index funds. And those that win during one time period often lose the next. The publication, Pensions & Investments compiled 10‐year