In my article Passive funds versus active funds, I explain that the majority of active funds underperform the market.

This news might feel very counterintuitive. I was certainly shocked when I first discovered this uncomfortable truth.

Perhaps it feels so absurd because the active fund management industry is geared up to provide superior returns:

• Fund managers pay well and are able to recruit talented graduates from the best universities
• Funds have access to the latest company news via expensive newswire services
• Funds produce expert analysis and apply the latest statistical techniques to generate insights and trading ideas
• Funds are led by veteran managers, hired on the basis of their personal reputation for stock picking. Star managers are, by definition, excellent at picking stocks and shares.  

In addition to this, investors research a range of funds before making an investment decision.

This allows an investor to avoid funds that:

• Have failed to beat their benchmark in recent periods
• Have patchy performance records over the long term
• Have failed to provide dividend growth to investors

This surely allows an investor to pick the ‘cream of the crop’, the best of the best.

So, how do all these advantages come to nothing? Why is the average result of these money-making machines sub-par? The answer is contained in what I coin the ‘GoldFish Dilemma’.

The goldfish dilemma

Imagine that an innovative fund management company decides that the finest investing mind in the world is not a human, but a fish.

It buys 20 goldfish and gives each prime specimen its own spacious tank.

The company creates 20 investment funds, one for each fish to ‘manage’.

Each morning, during a 1-minute ‘trading idea’ session the computer will randomly toggle between ‘buy’ and ‘sell’.

If the fish swims left, this will be interpreted as a ‘buy’. If it swims to the right, it has opted to sell. It will then toggle through potential purchases, or potential shares to sell. The investment shown on screen at the point the fish enters its little pirate ship home for the first time will be traded. The fish and the fish alone will determine the right time to buy and sell shares.

In this fairly random fashion, each fund begins trading independently from day one and manages a portfolio of £100,000 over the course of a year.

The results

We now jump to the end of the trading year. The accountants are called in and each fund is liquidated. How did the fish do?

The average performance of the fish is a return of 3.5%. Not bad for a brain smaller than a grain of rice. After all, the stock market rose by roughly the same amount during the year, so we would expect that the funds would generally rise in value.

The worst performing fish lost -40%. It had the misfortune of investing in Eddie Stobart Logistics plc during a rough period of time for the company.

The winning fish – ‘Nemo’ – was sat smugly on a portfolio of £180,000 – an 80% return. He had bet on a few high growth AIM-listed companies which enjoyed fivefold increases since.

Would you invest?

If you were invited into this bizarre office to meet the fishy operators of these funds – you would quickly understand that their results are essentially random. Scattered either side of the overall market return, some did well, some did less well, but most came ‘close’ to the average market return.

If I gave you the opportunity to invest in Nemo’s fund for the next financial year, would you take me up on the offer? Would you conclude that investing in fish-managed shares would be a good investment?

I expect that you’d quickly refuse this fishy-sounding offer.

Knowing that the results were entirely random, you would appreciate that the outperformance of Nemo was the result of pure luck. If given a chance again – there is no reason why this gilled genius would continue to beat the professionals at their day job.

With every new crop of fish, there will always be lucky ones that happen to perform well. This is an important point to make clear – when returns are randomly distributed around an average, there will always be lucky goldfish.

Back to the real world

When we look at the results of the actively managed fund industry – we see a very familiar set of results.

Each year, we find that some funds delivered high and some delivered low. Most funds came somewhere close to average.

The dilemma:

The dilemma is as follows:

If you pick a top-performing fund – how do you know whether the performance was driven by skill or blind luck? How can you tell apart a worthy winner from a lucky goldfish?

The problem is, you can’t.

Looking for good returns over a longer period doesn’t help. Yes, this will narrow your shortlist even further – but you could be simply splitting the ‘super lucky’ from the ‘rather lucky’.

Looking for higher returns again doesn’t help, as even random picking can occasionally produce spectacular results.

Can we even guess at what proportion of high performers are skilful versus lucky? Not really. All we do know is that there must be plenty of lucky fish among the top-of-table. We know this because statistically speaking, there must be.

Where returns are normally scattered around an average – there will always be outliers.

The depressing revelation

If we assume that fund returns are normally distributed around the market average, then you would expect to see as many winners as losers – with no overall bias either way.

If all funds used goldfish – this is how the marketplace would look.

If some fund managers do have star performers, then on top of this even spread distribution of returns, there would be extra positive results from these strong performers.

In other words – if the fund management industry had a real skill at stock picking, then there should be more winners than losers. The average fund must beat the overall stock market.

The good news is that they do – but only slightly. This tells us that there must be some skill involved. All of the information and knowledge advantages do appear to deliver a slight premium.

However, as stated in the opening paragraph, the average active fund underperforms the market after fees. This means that the cost of producing this premium is higher than the premium itself.

This is the equivalent of a tax accountant offering to help you avoid paying taxes when investing, then billing you for a higher amount than you saved. 

In this circumstance – it doesn’t make any sense to pay for the service. It would be a mistake for investors to pay for active management.

This is why I advocate for a passive approach to investing in shares through exchanged-traded funds (ETFs). For more information, read What are exchange traded funds?