Why Buffett and BlackRock Think You Should Fire Your Fund Manager

BlackRock to Cut Jobs, Fees in Active-Equity Shake Up

Are you good enough at picking stocks to beat the market? Not too many people would claim that. Is your asset manager good enough? The $10 trillion invested in active-management funds is a bet that the answer is yes. But more and more people are saying no, including the world’s largest asset manager, BlackRock, which is paring back its active-equities group. BlackRock is responding to a surge of money into what’s known as passive investing. It’s an approach endorsed by Warren Buffett, who thinks the smartest thing your money can do is climb into the hammock and take the rest of the day off. The debate over active vs. passive is upending the investment industry.

1. What’s meant by active investing?

It’s what used to just be called investing -- buying or selling individual stocks or bonds. More commonly these days, it means putting money into mutual funds whose managers make those case-by-case decisions for you. The idea is that professional money managers will get better returns than you, the average investor, will. Either way, somebody is making active decisions about what’s in a portfolio.

2. What about passive?

Passive investments track indexes, which are groups of securities that are alike in some way. Buying an index fund that owns every stock in the S&P 500, for instance, is a passive investment. As an investor you will do as well as that overall market, no better or worse. Exchange-traded funds, which are mutual funds that trade on an exchange just like stocks, are another common vehicle for passive investing.

3. Where did the passive-investing idea come from?

In a 1973 book, a Princeton professor named Burton Malkiel claimed that “a blindfolded monkey throwing darts at the stock listings” could do as well as a professional money manager. Malkiel didn’t dispute the idea that some managers could outperform. But as a group, he argued, they would produce the same results as the market, minus the fees they charge. Three years later, using the same logic, John C. Bogle, the founder of Vanguard Group, created the first index fund for retail investors, one that duplicated the S&P 500 Index. Bogle, too, believed that most active managers could do no better than the index over time. A number of studies have borne that out: A 2016 study by S&P Dow Jones Indices showed that about 90 percent of active stock managers failed to beat their index targets over the previous one-year, five-year and 10-year periods.

4. So passive funds outperform active ones?

The argument is that they do when cost is factored in. Bogle concluded that because active mutual funds charge higher fees, their actual performance would generally be worse than their index counterparts. A typical active stock fund at Fidelity Investments might charge 70 cents for every $100 invested. Fidelity’s 500 Index Fund charges 5 cents. Even if an active fund produced somewhat better returns, over time the cost savings of the passive approach would outweigh that difference in performance. Vanguard, with its emphasis on low costs, grew slowly at first. Today it is the largest mutual fund company in the world.

5. Where are investors putting their money?

In the last few years, more has been going into passive funds than active. In 2016, investors pulled more than $380 billion from actively managed mutual funds while pouring almost $480 billion in passive investments. It’s a trend that has been accelerating in recent years. But active funds still lead in one important category: They have about $10 trillion in assets, compared with about $5.8 trillion in passive funds and ETFs.

6. Is this being driven by mom-and-pop investors?

Plenty of individual investors have made the switch. But so have institutional investors, and even a lot of financial advisers. When they were paid commissions for what they sold, advisers had no reason to sell index funds. Today, most advisers are paid a flat fee or a percentage of the assets they’re managing, which gives them an incentive to sell low-cost products that hold down overall client fees. At Vanguard, advisers now contribute more new cash than individuals or retirement plans.

7. What are really rich investors and hedge funds doing?

Hedge funds, which charge significantly higher fees than mutual funds, are in the same boat as other active managers. As a group, they have not matched the performance of index funds, so clients, including some large public pension funds, have pulled their money. Buffett, in his most recent annual letter, estimated that investors wasted more than $100 billion on high-fee Wall Street money managers over the past 10 years. “Both large and small investors should stick with low-cost index funds,” he wrote.

8. What do active managers say in their defense?

For one thing, that the period since the financial crisis of 2008 has been an abnormal one, with many stocks moving in lockstep, rather than trading on their fundamentals. They say that’s likely to diminish as interest rates climb and the market moves into an environment that will play to the strengths of managers who pick stocks and bonds. They also say that all the money pouring into indexes that treat good and bad companies alike will distort prices, creating more opportunities for those who can spot bargains and avoid overpriced securities.

9. Who’s benefiting from the shift?

Vanguard is a big winner. So is BlackRock, which is the world leader in exchange-traded funds -- a fact that certainly played into its decision to cut back on its actively managed funds. Other companies that specialize in active management, like Fidelity and Franklin Resources, both of which have seen investors leave, are also slimming down. Others are merging or even closing down. Still others are working to develop funds that combine active and passive management, like the so-called smart-beta funds that track groups of securities based on factors such as valuation, momentum and profitability.

10. Is Buffett putting his money into index funds?

No. He really does outperform the market -- or at least has, so far.

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