- Bill Miller
“I like the idea of having a little action. That may not be good from a logical point of view, but it's good from an emotional point of view.”
- Walter Schloss
“Don't think for a moment that small investors are the only ones guilty of too much attention to the rear-view mirror.”
- Warren Buffett
No matter how much the data show, it is very difficult for investors to grasp that indexing generally beats active management, low-cost funds usually beat high-cost funds, and most investors' behaviors create a substantial gap between investor and fund returns. And an enormous amount of outstanding research is out there that discusses just these issues. I wrote about much of this in 2015 - 2016 when I was a regular contributor to GuruFocus and an investment manager of the Nintai Charitable Trust. So, after roughly six years of being a professional asset manager with a public performance record, I thought it might be a good time to revisit these themes and see if there have been any changes in the investment world.
Active versus Passive Investing
The news over the past decade has been both good and bad. The good news is that there has been a seismic shift from actively managed funds to index-based investing. According to the Financial Times, US stock market ownership has gone from 20% active and 8% passive in 2011 to 16% passive and 14% active in 2021. The ten largest fund houses manage the bulk of passive assets. Actively managed domestic equity mutual funds have suffered net outflows since 2005, even as their passive peers have inflows nearly yearly over the past decade. Index-tracking ETFs have proved more popular still. US-listed ETFs, overwhelmingly passive, have seen their assets rise fivefold to $7.2bn since 2012.
Fund Costs Decrease
Another piece of good news has been that the costs of both mutual funds and exchange-traded funds (ETFs) have decreased significantly over the past decade. According to the Investment Company Institute (ICI), in 2021, the average expense ratio of actively managed equity mutual funds fell to 0.68 percent, down from 1.08 percent in 1996. Likewise, index equity mutual fund expense ratios fell from 0.27 percent in 1996 to 0.06 percent in 2021. Investor interest in lower-cost equity mutual funds, both actively managed and indexed, has fueled this trend, as has asset growth and the resulting economies of scale. In 2021, the expense ratios of index equity ETFs were 0.16 percent (down from 0.34 percent in 2009). Likewise, expense ratios of index bond ETFs, down from a peak of 0.26 percent in 2013, fell to 0.12 percent in 2021.
Investor Returns versus Fund Returns
So, what’s the bad news? Investor returns continue to leg fund returns. According to Morningstar, the 2022 “Mind The Gap” study of dollar-weighted returns (also known as investor returns) finds investors earned about 9.3% per year on the average dollar they invested in mutual funds and ETFs over the ten years that ended December 31, 2021. This is about 1.7 percentage points less than the total returns their fund investments generated over the same period. This shortfall, or gap, stems from poorly timed purchases and sales of fund shares, which cost investors nearly one-sixth the return they would have earned if they had bought and held. This 1.7-percentage-point gap between investor returns and total returns is in line with the gaps found for the four previous rolling 10-year periods. While funds can decrease costs and investors can focus on passive investments, the sad fact is that human behaviors, such as recency bias, are challenging to overcome or reform.
Themes for Further Discussion
With the context of these three broad themes, I'd like to spend time over the following few articles to discuss some issues that profoundly affect investor returns over the long term. These will include the following:
Low versus High Fees: Evidence suggests that funds with the highest overall fees grossly underperform those with the lowest total costs. I will discuss what causes such a disparity, what fees are not reported, and why investors continue investing their money in such funds and their management. Issues include why “mutual funds” aren’t mutual at all, why some funds are immune to economies of scale, and why turnover is a substantial marker for poor performance. In the words of Jack Bogle, you generally get what you don’t pay for.
Active versus Passive: While it’s great to see such a move from active to passive, a considerable amount of money remains in actively managed funds that underachieve their proxies over the short and long term. David Swensen once said, "the mutual fund industry is not an investment management industry. It's a marketing industry.” Part of why so much money remains in active management is that many fund companies have convinced investors they outperform when they don’t. I’ll look at a couple of these “guru” managers and their investment companies and discuss why active management is sometimes worse than it seems.
Complicated versus Simple: When the idea of mutual funds became a reality in the 1920s (think MFS’ Massachusetts Investment Trust) and again when Jack Bogle created the (nearly) first index fund in the 1970s, the model was relatively simple. Allow investors to own a broad selection (or the entire selection in Vanguard’s case) of stocks with minimal trading and associated cost and tax burdens. But Wall Street has always succeeded in creating financial tools that make investment managers profit first and then investors second. The primary method in achieving such financial success was to make investment tools increasingly complex, customized, and (surprise!) expensive. This constant pressure to innovate (and drive Wall Street profitability) has led to a $20 trillion market filled with hard-to-understand and even harder-to-employ specialty investment options. In a recent article (“Why Investment Complexity Is Not Your Friend”), Morningstar’s Amy Arnott writes that “during the past three years, for example, fund companies rolled out at least 139 funds focusing on options trading, 53 leveraged equity, 39 digital assets (aka cryptocurrency), 26 trading—inverse equity, 274 sector, and 205 thematic funds.” She reports that roughly 14% of the total funds covered by Morningstar provide core investment coverage. Complexity offers little opportunity for the average investor but significant profits for the fund companies.
Over the next several months, I will cover these themes in more detail. My goal isn’t to poke fun at Wall Street in general or individual investment shops in particular. Rather, I want to focus on the fact that investors can do best by keeping things simple, watching their costs, and understanding that action in any form creates frictional costs that come directly out of their pockets. I want to be upfront with my readers. I’m a professional investment manager who charges customers a percentage fee of total assets under management. Our goal at Nintai is not to be part of the problem but part of the solution. To achieve that, the answer is quite simple. Nintai must outperform the markets over and above our fees to add value to our investment partners. It’s that simple. We can do this by keeping costs at a minimum, trading infrequently, and utilizing an investment process that chooses quality companies generating significantly higher returns on capital versus their weighted average cost of capital. We believe, and the records show, that we have provided real value to our clients over our investment career.
As always, we look forward to your thoughts and comments.
DISCLOSURE: Nintai Investments nor Mr. Macpherson has no positions in any stocks mentioned and has no plans to buy any new positions in the stocks mentioned within the next 72 hours.
 “Passive fund ownership of US stocks overtakes active for first time,” Financial Times, June 6, 2022. https://www.ft.com/content/27b5e047-5080-4ebb-b02a-0bf4a3b9bc08
 “Trends in the Expenses and Fees of Funds, 2021”, ICI Research Perspective, March 2022, Volume 28, No. 2
 “Mind the Gap – 2022”, Morningstar Portfolio and Planning Research, July 2022
 Of course, past performance is absolutely no guarantee of future returns.