Think strategy and cost when picking investments

The concept that we should make things as simple as possible, but not simpler, is often attributed to Albert Einstein. I’m frequently reminded of this idea when I read articles on investing.

We certainly don’t want to overcomplicate investing, but getting it right does require critical thinking. We have to make sure we draw the appropriate conclusions about what we read. Without a closer look at what the numbers really tell us, we might be led down a less than optimal (and possibly quite costly) path with our investments.

A recent article on industry website Financial Planning, “Active vs. Passive? The Unexpected Winner,” made me think about this issue exactly. It’s all factual data, I thought to myself, but is it of any use to investors? Is there a better way to think about and use investment return data?

Active vs. passive funds

The article compares the three-year returns of the 20 top-performing large-capitalization growth active funds with the returns of the 20 top-performing large-cap growth passive funds. These top active funds have a higher average return than the top passive funds in the same category, the article reports. However, isn’t this what we would expect? More importantly, what do we do with this information, anyway?

Active funds seek to beat the market in their category. Their returns are compared to those of the benchmark, often a broad-market index that tracks the returns of the category at large. Because active funds want to best their benchmark, they must have different holdings.

By design, each active fund’s returns will likely fluctuate from the benchmark, often substantially. Sometimes their returns are much higher and sometimes they are significantly lower. So looking only at the 20 top-performing active funds will show us a picture of funds with outsize gains. Naturally, the returns of these funds will be much higher than those of the 20 top-performing passive funds, which typically tend to look more like the benchmark.

What’s more, a Vanguard study shows that on average, active management reduces a portfolio’s returns and increases its volatility compared with a passive index strategy using the same asset allocation.

Picking the winners

So, are the three-year returns of the 20 top-performing actively managed funds useful to me in my decision making? The short answer is no. To take advantage of this information, you’ve got to pick the winning funds in advance. We see the investing disclaimer almost everywhere: “Past performance is no indication of future performance.” And yet, of course, it’s the future performance that we’re concerned with.

But why not simply pick a past winner, say a fund in the top 20%, to invest in? While that at first seems like a good idea, anotherVanguard study shows how difficult it is to tell if those winners will continue to be top performers in the future. The study found that persistence of performance among past winners is no more predictable than flipping a coin.

For example, the study shows that of the funds that performed in the top 20% in the five-year period ending in 2007, only 12% stayed in the top quintile for the following five-year period, while 28% fell to the lowest quintile and 14% merged or closed. In other words, if an investor picked a fund in the top 20% and then looked at its ranking five years later, it’s three times more likely that his or her fund would end up in the lowest quintile or the closed or merged fund group than to have stayed in the top 20% group.

Better question

Rather than asking how the returns of the best-performing active funds compare to those of the best-performing passive funds, a more relevant question might be which style did better over the long run? In other words, which type, active or passive funds, had better returns on average in a given category and period?

To answer that question, we can refer to a June 2015 paper from investment research company Morningstar. While it doesn’t show the specific three-year period discussed in the Financial Planning article, it provides a comparison for the 10-year period ending Dec. 31, 2014.

When the average returns for the large-cap growth category are examined, the active versus passive contest comes up with a clear winner. For the 10-year period ending Dec. 31, 2014, the passive-fund managers outperformed the active-fund managers by a large margin.

In fact, the report says: “Large-growth active managers had the worst showing. Just 16.9% of U.S. large-growth managers were able to best their passive counterparts over the trailing 10-year period, though the success rate improved to 28.9% when limited to the lowest-cost large-growth funds.”

Expense ratios

If past performance doesn’t help us predict future fund performance, what other factors might we examine? Investment costs. Morningstar reports that the 2014 average asset-weighted expense ratio across all funds was 0.64%, but expenses can range from less than 0.3% to 2% or more, depending on various factors.

In a study on predicting fund success, Morningstar director of manager research Russ Kinnel suggests: “Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” He adds, “In every single time period and data point tested, low-cost funds beat high-cost funds.”

Kinnel’s emphasis on the importance of costs is especially important as it applies to both active and passive funds. Expense ratios may vary by category, but Vanguard’s research shows an inverse relationship between investment performance and cost across multiple categories of funds, both active and passive.

Nobel Prize winner and Stanford University finance professor William Sharpe espouses a similar message on the importance of minimizing expenses. In his paper on investment expenses, Sharpe estimates that retirement investors who choose low-cost investments could have a retirement standard of living 20% higher than a comparable individual who selected high-cost investments.

Investment expert Charles Ellis, who has taught at Harvard and Yale, also cautions that while some active funds will outperform the market, investors should carefully consider fund expenses.

In his article, “Investment Management Fees Are (Much) Higher Than You Think,” Ellis writes that, “Extensive, undeniable data show that identifying in advance any one particular investment manager who will — after costs, taxes, and fees — achieve the holy grail of beating the market is highly improbable.” He goes on: “Some managers will always beat the market, but we have no reliable way of determining in advance which managers will be the lucky ones.”

Bottom line

So rather than examining the top-performing funds based on their returns over the last few years, investors would do well to consider two key factors: the long-term average returns of fund strategies and the costs associated with a given fund.

Unless you have a proven method to pick winning fund managers in advance, the average returns of a fund style are still more relevant than the returns of the top-performers. Investors must also carefully examine the total expenses of the funds they select, as studies have shown an inverse relationship between investment performance and cost.

Thinking critically about investment returns and fees will help investors make decisions that could result in better returns and greater investing success over the long run.

This article first appeared at NerdWallet.