They're gone. But this is how much they cost you.
You thought that investment funds were bad news? You were suspicious of their high charges, murky investment processes, and propensity to hug their respective benchmarks?
Well, congratulations: you weren't wrong. Here at The Motley Fool, we've long taken a dim view of investment funds. But here's the kicker. New research shows that you were in fact more correct than you might have suspected.
And that's because by the time the figures are usually compiled, the bodies have quite literally been buried.
Survivorship bias
It's comparatively rare for detailed analyses of active investing -- taking into account every fund on the market -- to be carried out. Back in the early days of the Fool, I remember reading some statistics pointing out that most funds underperform the market, but I haven't seen very much detailed research since.
But these 'whole market' analyses, by definition, actually turn out to miss out a whole swathe of funds. That's because they look only at the funds that are presently on sale in the market.
And as research published this week by passive fund management firm Vanguard points out, that's an important omission:
"Prior to this research, publicly available fund performance returns have overstated the effectiveness of active management by only including surviving funds, not those that had been merged or closed. This 'survivorship bias' must be considered, as the returns from liquidated funds disappear from the data, providing a distorted view of the performance of actively managed funds."
Cadavers unearthed
And you won't be surprised to learn what including the performance of those funds that didn't survive does to the analysis. Let's put it this way: they weren't closed down because they were rip-roaring successes.
In fact, over an eighteen-month period prior to their termination, these liquidated or merged funds performed, on average, 2.65% below their respective benchmarks.
And taking this survivorship bias into account, it turns out that over five years, only about 25% of actively-managed UK equity funds investing in large companies did better than the FTSE 350.
Er, yes: you read that correctly. And put another way, it's even more stark a conclusion. Three quarters of them didn't outperform the FTSE 350.
And a similar story, it seems, can be found in the UK actively-managed bond sector. Over five years, the apparent outperformance of a majority of government and corporate bond sectors evaporates when closed or merged funds are included in the analysis.
Costs matter
Long-time Fool readers won't be surprised as to why this under-performance arises. It comes down to costs, in short.
Investing is a 'zero‑sum game', says Vanguard: for every winner, there has to be a loser. So in practice, on average and over time, managers of active funds will underperform the index due to costs. In other words, after costs are accounted for, investing becomes 'less than a zero‑sum game'.
And while some active managers do outperform the market, identifying persistently-outperforming funds in advance is extremely difficult. Vanguard's analysis highlights that only 22% of top-ranked funds in the five years to 2004 remained in the top rank over the subsequent five years to 2009.
In fact, a top‑performing fund over the five-year period to the end of 2004 was almost as likely to end up in the bottom 20% per cent band over next five years as it was to staying in the top band.
And shockingly, there was a 42% chance that a top‑ranked fund would go on to underperform in the following five‑year periods, or be closed or merged.
Banging the drum
Now, Vanguard isn't going to the trouble and expense of performing such analyses out of the goodness of its heart. There's an agenda, and a very clear one.
Famous in the US market for the low-cost index trackers created by founder John Bogle, Vanguard is trying to gain the same traction over here as it has over there.
And this research is intended to underpin the merits of passive investment in the sorts of low-cost funds that Vanguard excels in.
But with that health warning in place, the argument in favour of passive investments such as index funds is very clear cut. The total expense ratio for the average UK-domiciled equity index fund is 0.8% compared to 1.7% for the average actively-managed fund.
And why pay double the costs when the investment outcome is no better -- and possibly worse? It's an argument that it's difficult to refute.
More from Malcolm Wheatley:
> Malcolm holds trackers from Vanguard in a SIPP and ISA.
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