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This is a follow up post on Why Index Fund ? ( Case1 here )

Case 2 : Why not Actively Managed Fund for better returns ?

Financial Freedom can be achieved only when money compounds on a longer run. If we are focused on Short-Term returns other Mutual Fund’s may perform better , but given the Fee and Tax implications even Short-Term Mutual funds have not been able to beat the Market Return.

Market Return usually is the Index – Sensex or Nifty 

A well known study has shown that “Even Monkeys can beat the market”.

Q: What is all this monkey business? It started in 1973 when Princeton University professor Burton Malkiel claimed in his bestselling book, A Random Walk Down Wall Street, that “A blindfolded monkey throwing darts at a newspaper financial pages could select a portfolio that would do just as well as one carefully selected by experts.” . “Malkiel was wrong,” stated Rob Arnott, CEO of Research Affiliates, while speaking at the IMN Global Indexing and ETFs conference earlier this month. “The monkeys have done a much better job than both the experts and the stock market.” – Source : https://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-can-beat-the-market

On a longer run only 4% of Fund managers can beat the index/market. So why pay a fee to underperform and help plan your Advisors Financial Freedom instead of yours. 

Warren Buffet in one of his Shareholder meetings had openly suggested that Fund Managers take exorbitant Fees which their Funds Performance could not justify. This got a lot of Hedge Fund Managers furious and led to the Famous 1 Million Dollar Bet. Protégé Partners LLC accepted, and the two parties placed a million-dollar bet. To keep it fair the Hedge Fund Managers were allowed to create 5 Funds and their cumulative return was to beat the Index Fund !

https://youtu.be/DM564iYlj_8

Hedge Fund Managers have far more power than that of Mutual Fund. Hedge Fund Managers can Short the market , sell underperforming assets and can invest anywhere they want to.

The bet began in 2007 and by 2016 the Hedge Fund Manager’s had lost handsomely !! Hedge Fund average was 22% while that of Index Fund was a whopping 85%.

The Million Dollar won in the above bet was given out in charity by Buffet.

Warren Buffet after his death plans to donate most of his wealth and put the remaining to a passively managed Fund such as an Index Fund. Having gained his wealth from stocks, Buffett has said he believes the value of his estate would be best maintained using the stock indexes.

Mutual Funds have this Disclaimer “Past performance is no guarantee of future results”. If only people would take this disclaimer seriously. It’s like a statutory warning issued on Cigarette Packs “Smoking causes Cancer” , earlier this used to be “Smoking may cause Cancer” that gave smokers a small hope that few might get cancer and never them . Have you seen the gory pictures of throat cancer that go on every cigarette pack these days?? .

The Disclaimer on Mutual Funds should actually read “Past Performance might be luck, in the future, our luck will run out for sure” with a picture of a person who went broke.

This is a classic case of Survivorship Bias.

Survivorship bias or survival bias is the logical error of concentrating on the people or things that made it past some selection process and overlooking those that did not, typically because of their lack of visibility. This can lead to false conclusions in several different ways. It is a form of selection bias. – Source : https://en.wikipedia.org/wiki/Survivorship_bias

Let’s look at a few examples

Example 1

During World War II, the statistician Abraham Wald took survivorship bias into his calculations when considering how to minimize bomber losses to enemy fire.Researchers from the Center for Naval Analyses had conducted a study of the damage done to aircraft that had returned from missions, and had recommended that armor be added to the areas that showed the most damage.Wald noted that the study only considered the aircraft that had survived their missions—the bombers that had been shot down were not present for the damage assessment.The holes in the returning aircraft, then, represented areas where a bomber could take damage and still return home safely. Wald proposed that the Navy reinforce areas where the returning aircraft were unscathed, since those were the areas that, if hit, would cause the plane to be lost. Source – https://en.wikipedia.org/wiki/Survivorship_bias

Example 2

Army surgeons about armor plates: If you are tasked to develop a better personal armor for your soldiers, and you ask the combat surgeons which area do they perform surgery the most. They would say “arms” or “legs” and you will be misled by “survivorship bias” to create thicker armors for arms and legs.

The surgeons would not say “heart” or “liver” because whomever are shot in those areas are long dead before reaching surgery table.

Example 3

Coin Flippers in a room : We put 100 Managers in a room and ask them to flip a coin. By probability theory at least 50 Managers will be able to get the result you asked for ( Say HEAD ). We then send the losing Managers out of the room and continue the experiment with remaining 50. This time we have 25 Managers that were able to get what we asked for. ( Say HEAD again ). If we continue this experiment we will end up with ~4 Managers in the room. Can we now assume that these 4 Managers are extremely talented in flipping coins and can always get you the desired outcome ?

Coin Flippers in a room is exactly what is happening with today’s Fund Managers and their Funds. The Funds have been on top only due to the fact that the losers in the game are not being spoken about. There have been thousands of Mutual Funds that have been shutdown due to bad performance and the remaining few that claim to have beaten the market have the uncertainty attached to them , whether it was because of Fund Manager’s SKILL or pure LUCK is always debatable.

You might have experienced this first hand… Why is it that a Fund which was a rock star performer does bad as soon me/you start investing in them ?

Entire stock Market is a ZERO SUM game. If one Fund Manager is making profits, someone out there must be making losses. If we get this basics of stock market, probably we all will tread our financial path very carefully.

Non performing funds are merged with the one having high returns by Fund Houses to hide their shortcomings. The cycle is repeated and customers are made to believe that all is well.

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