Active management costs

Active management portfolio: yes or not?

This is one of the most important debates in the world of investing

An issue that has a lot to do with the inherent problem of short-term trading: the fact that it trades too much. So now wonder that the intraday traders obtain such disastrous results often.

However, it is in the long-term investment world where we can see how problematic trying to be active really is since there are several studies that support this.

The fact is that there are not a significant number of active managers who beat the market consistently.

In fact, that number is very limited and for certain periods of time only.

Sometimes people read the story of some Chicago old trader from the Pit and believe that he used to make money trading or investing when the truth is that the guy was working as a market maker or dealer, which is totally opposite to the trading that 99.9% of people do.

Mark Hebner, from IFA group, wrote an article reminding us how problematic those funds with active management are.

The trick always works the same.

If we look at the data of one or two years of course we will find many funds and hedge funds that are beating the S&P 500.

Sometimes they beat the market by a huge difference, in years like 2008 when even when the market was crashing there were some people profiting from it.

Great.

The problem is, as the article reminds us, that when we widen the years of the analysis the great majority of funds end up not being able to beat the general market.

In fact, one of the fundamental causes of that is the fact that an increasing number of operations or trades done every year are quite detrimental to the final result.

Not to mention the inherent fund costs (expense ratios), which, curiously, area bigger in active funds.

Therefore, the wise choice for normal investors should be to buy passive funds which statistics tell us that approximate the return of the real market.

As the author explains very well, if the fund manager is, truly, someone with a lot of talent, we should wait that the next year, the probability that this fund beats the market again should be more than 50%.

If luck was involved then the return of the funds should be approximately 50% of the best funds.

  Expected result Final result
Year 1 50% 30.02%
Year 2 25% 15.61%
Year 3 12.5% 9.87%
Year 4 6.25% 3.59%

Out of 1115 funds studied only one was able to be in the group of the best 50% funds of the year during 5 years.

This is many times due to the costs of the funds that make it very difficult for it to beat the market, even if it has a good alpha.

As Russel Kinnel, from Morningstar funds said:

“If there is anything sure in the world of funds investment is that the management costs are very helpful for taking a good decision. In every period of time we have analyzed the funds with low costs beat the funds with higher costs. Therefore management costs are a useful tool to predict what funds are going to have a better return.”

What does this mean?

It means that no matter how hard we try the more number of trades we do the bigger the chance that our account is going to suffer.

Costs in Forex and other assets

If this happens when we are investing for the long-term, I can assure you that in the short-term trading it reaches unthinkable levels as to cause that nearly 100% of those who try it lose.

Curiously, the bigger part of gurus, web and trading experts say that the problem lies in “psychology”, this and that, but the truth is that 99% of times the real reason is the costs associated to too much trading.

This is not to say that it is totally impossible to win doing short-term trading but it is true that it is very complicated, at least to do it consistently.

Anyone who has aspirations to become a trader should study the world of investing funds and ask themselves some questions.

Why do not hedge fund managers and other fund managers do not trade too much?

Why those who invest in the long-term do not swap their portfolios too much during a year?

Who are, then, the winners in the short-term trading game?

Guess.

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