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The Consequences of Underperformance

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The following message is my reply to an online publication that made the argument for actively managed funds over passive index funds. The author discussed fees for both vehicles so it is not mentioned in this response. Though the message is intended to address actively managed mutual funds, the same can be applied to any attempt to outperform.
One issue with actively managed funds is that the lead manager can bail out to a different fund or company at any time. This is like a high school athlete who goes to a particular university to play for a coach he/she likes only to have the coach get fired, quit or move on to other endeavors once they get there. Even though company literature paints an exciting picture for their individual funds, it all comes down the individual manager if outperformance is the goal.

Tax considerations are another reason to move to index funds. Not everyone holds their investments in tax free vehicles and while it's fun to reinvest those large ST or LT cap gains, the tax bill at the end of the year isn't so much fun.

What about those who underperform? If a fund underperforms by 1-2%, it may be able to make up that shortfall in the future. But what about the fund that underperforms by a greater margin such as 5-15%? The famous reference is use is 'legendary' Bill Miller at Legg Mason who outperformed for many years only to get nearly all of those gains crushed in 2008-2009 by a few bad picks (BSC, LEH, Countrywide).

The common belief is that the stock market has returned some 8-12% since 1890 (depending on who you read), but that statistic is very misleading as most gains occurred during brief moments in history even though it as largely been perpetuated otherwise by the fee machine on wall street in recent years. What most individuals are facing right now is the result of a savings shortfall. Those who planned on retirement didn't save enough because they were showered with the idea that 10-12% gains (or more in 1980's and 1990's booms) would make up for any savings shortfalls in the end. Even worse, that problem is compounded by those took on additional risk to cover for that shortfall. What happens to those who have consistently underperformed an index fund by a significant margin (5-15% or more)?

The above argument isn't only an issue with the individual investor. All one needs to do is Google 'pension fund shortfall' to see how epidemic the problem is. There's a reason why the pension funds are making the switch to passive indexing from active management.

Finally, too many investors treat markets and savings like a competition and feel that if they can outperform on a YOY basis, they're doing the equivalent of winning some kind of race. Back to what was mentioned earlier- what about those who underperform? The outperformers might pull 1-3% over their benchmark (even though their benchmark is almost always incorrect), but underperformers can easily do -5% or more of their benchmark. A 5% underperformance in one year is an enormous shortfall to make up for- even if you're young.

What's wrong with being 'average' in the stock market and achieving the total stock market return? What's wrong with knowing you'll get the market return not only YOY, but also over the long run by consistently contributing to index funds?

Our individual savings rate is the only thing that we have any control over. No matter how you roll the dice, you have to make the right sacrifices by saving appropriate amounts today in order to reach your future goals.

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