Don’t Be a “Low-Information” Investor

2016-05-04

There’s a lot of talk in the media about “low-information” voters. Ted Cruz may be responsible for coining the term. He referred to supporters of Donald Trump as those “who have relatively low information, who are not that engaged and who are angry.” He observed that other candidates are beating Trump “when voters get more engaged and they get more informed.”

The danger of “low information”

I see a parallel between the worlds of politics and investing. The securities industry preys on “low-information” investors who don’t know the underlying data. These investors are inundated by pundits, analysts and other “financial pros” who claim the ability to pick outperforming stocks, time the markets and identify the next “hot” mutual fund or alternative investment. When investors get “more engaged” and “more informed,” they understand that efforts to “beat the market” simply enrich brokers while likely causing them to underperform comparable index funds.

“High-information” investors are taking action

“High-information” investors understand this reality: It’s not that it is impossible to “beat the market.” Rather, it’s that the odds of doing so are so small it makes no sense to try. It’s for this reason that,according to Morningstar, “investors added $361.8 billion to all passively managed stock and bond funds in the U.S. in the first 11 months of 2015, while pulling $139.5 billion from actively managed funds.”

Misleading arguments for active management

I recently heard a broker make a very clever argument for active management, which was geared to take advantage of a certain lack of sophistication among some investors. Here’s what he said: “If you invest in index funds, 100 percent of those funds will underperform their benchmark index. With active management, you know that at least some funds will outperform the index.”

This statement is technically true, but fundamentally misleading. You can’t buy the index. But you can purchase funds that track the index. Doing so incurs a management fee. As a result, investors earn the return of the index less this fee. Therefore, all index funds will underperform the index.

However, because many index funds charge very low fees, the majority of actively managed funds underperform both their benchmark index and index funds tracking that index.

Active management vs. index funds

My colleague, Larry Swedroe, recently analyzed the performance of actively managed funds that attempted to beat different indexes. He compared this performance to comparable index funds managed by Vanguard (and not to the index). Here’s what he found for the 10-year period from 2006 through 2015:

The Vanguard 500 Index Fund (VFINX) outperformed 77 percent of comparable actively managed funds.
The Vanguard Value Index Fund (VIVAX) outperformed 68 percent of comparable actively managed funds.
The Vanguard Small Cap Index Fund (NAESX) outperformed 85 percent of comparable actively managed funds.
The Vanguard Small Cap Value Index Fund (VISVX) outperformed 79 percent of comparable actively managed funds.

Lack of persistence

To beat the returns of these index funds, your broker would have to identify the small minority of actively managed funds likely to outperform them prospectively. This is an exceedingly difficult task. According to an analysis by Standard & Poor’s, only 7.48 percent of large-cap funds, 3.06 percent of mid-cap funds and 7.43 percent of small-cap funds maintained top-half performance over five consecutive 12-month periods.

Think about this data for a moment. If your broker claims the ability to pick an outperforming mutual fund, ask for details on the methodology he or she is using. If you are told the methodology is past performance, you know this can’t be right. There’s an inverse relationship between past and future performance.

Become an evidence-based investor

If you understand the low odds of picking an outperforming actively managed fund over the long term, as well as the lack of persistence among the funds that do outperform, you’ve made a giant leap toward transitioning from a low-information to a high-information investor.

Now fire your “market-beating” broker and become an evidence-based investor.

This commentary originally appeared March 22 on HuffingtonPost.com

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