Why pay for underperformance?
Recent financial news once again indicate that active managers underperform benchmarks. What is shocking this time is that nearly 85% of the managers underperformed their performance benchmarks, which usually are S&P indices related to the industries in which the funds invest.
Active fund managers are hired to add value by their services. This leads to multiple fees the investors pay. First, there’s a management fee. Then, there is administrative fee. In addition, investors are charged 12B-1 fees that for brokerage commissions and promotions. All these fees can approach (and sometimes exceed) 2% of invested capital annually, whether a fund makes money or not. (On top of these, there are other fees such as load fees).
Quite often, after accounting for the fees, the managers return less than their performance index. In fact, 85% of them do return less, and some of these much less. (Indeed, many managers underperform even before the fees are accounted for.)
This brings into serious questioning the sense of hiring a manager to actively manage the fund if they can’t beat the index. As a result, more and more investors are selecting index funds, which are passively managed investment vehicles meant to replicate the benchmark by investing in the shares that are represented in the index.
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Most mutual fund managers underperform their benchmarks. This means there's no extra value added for all the fees paid by investors.