Short answer: Actively managed funds do worse because they have more overhead—money managers cost money, and, on average, they don’t bring in more money than they cost.
There’s also the whole thing about the market not being quite efficient. If you can outperform the market, you can use the same strategy with more money in order to make more money, up until you start trying to buy and sell enough stock that you actually change the market. As a result, the people who are best at predicting the market will control it, and it will be efficient. But it has to be just inefficient enough to pay them enough to keep doing it. The same amount of money would have to come from other people trying to predict the market and failing. As a result, an average person would have a small expected loss that goes to those people, and if the actively managed funds are just hiring average people, they’ll lose money.
This makes sense. It’s like playing poker at a raked table: the “average” return of playing poker at an unraked table is zero dollars, because every dollar that someone wins is also a dollar that someone loses, but at a raked table, the house gets a cut of each pot, so the “average” return is negative. Similarly, every dollar of “above-average returns” earned in a market has to have a corresponding dollar of “below-average returns”. However, actively managed funds are like playing in a raked game: the money managers have to get paid, so they have to do
better than average in order to earn “average” returns for investors.
Actively managed funds do worse because they have more overhead
It’s not clear here, but when I first heard this they made it pretty clear that it was doing worse selecting investments. The extra overhead was an additional problem.
Under-diversifying increases risk without a commensurate increase in reward. It does not decrease reward, so it would not result in actively managed funds doing worse on average.
So under-diversified portfolios will under perform...
If I can invest in either of two portfolios, where one is LogNorm(1.25, 0.5), and the other is LogNorm(1,1), which should I prefer? They have the same mean, but my expected return over time still is dominated by one that has a lower standard deviation. (Try it in excel.)
If you’re looking at long-term results, you don’t really want the (arithmetic) mean of short-term results, you want the geometric mean (or, equivalently, the arithmetic mean of logarithmic short-term results). So the first of those portfolios is unambiguously better if what you care about is typical long-term performance.
We’re not arguing about what’s a good idea. We’re arguing about what could cause actively managed funds to do worse on average. I suppose it’s possible that the statistic I saw was calculated using a geometric mean, or even a median.
If you look at the single period mean, it will not represent the portfolio return. That’s why the expectation of an RV in a single period is insufficient information for looking at the return, and why we want to reduce volatility, and preserve expected.
Short answer: Actively managed funds do worse because they have more overhead—money managers cost money, and, on average, they don’t bring in more money than they cost.
This makes sense. It’s like playing poker at a raked table: the “average” return of playing poker at an unraked table is zero dollars, because every dollar that someone wins is also a dollar that someone loses, but at a raked table, the house gets a cut of each pot, so the “average” return is negative. Similarly, every dollar of “above-average returns” earned in a market has to have a corresponding dollar of “below-average returns”. However, actively managed funds are like playing in a raked game: the money managers have to get paid, so they have to do better than average in order to earn “average” returns for investors.
It’s not clear here, but when I first heard this they made it pretty clear that it was doing worse selecting investments. The extra overhead was an additional problem.
You are correct; one simple reason is that they tend to under diversify, and make correlated bets, which undermines the benefits of diversification.
Under-diversifying increases risk without a commensurate increase in reward. It does not decrease reward, so it would not result in actively managed funds doing worse on average.
So under-diversified portfolios will under perform...
If I can invest in either of two portfolios, where one is LogNorm(1.25, 0.5), and the other is LogNorm(1,1), which should I prefer? They have the same mean, but my expected return over time still is dominated by one that has a lower standard deviation. (Try it in excel.)
If you’re looking at long-term results, you don’t really want the (arithmetic) mean of short-term results, you want the geometric mean (or, equivalently, the arithmetic mean of logarithmic short-term results). So the first of those portfolios is unambiguously better if what you care about is typical long-term performance.
We’re not arguing about what’s a good idea. We’re arguing about what could cause actively managed funds to do worse on average. I suppose it’s possible that the statistic I saw was calculated using a geometric mean, or even a median.
Exactly.
If you look at the single period mean, it will not represent the portfolio return. That’s why the expectation of an RV in a single period is insufficient information for looking at the return, and why we want to reduce volatility, and preserve expected.
Good answer.