Active vs Passive Mutual Funds ... the debate goes on ... and on
motivated by discussions on NFB and Morningstar

Every month there's a discussion concerning whether passively managed Mutual Funds (investing, for example, in some Index like the S&P500) beat actively managed funds (where the Fund manager uses his own criteria for buying stocks and bonds).

Anyway, I always felt that the argument(s) in favour of passive were weak (to say the least).

>What arguments?
Arguments ... uh, something like: "The S&P beat 75 percent of all actively managed Funds".
I always felt that one should consider not the returns of the average Fund, but rather the returns of the average "active" Investor.

>Huh? Active Investor?
The ones who invest in actively managed Funds.
Anyway, my thinking was, if 99.9% of "active" investors stick their money in "active" Funds that consistently beat the S&P, and only 0.1% invest in those other, lousy Funds that consistently lose to the S&P, then why would the returns of the average "active" Fund be relevant?
Surely one should consider the returns of the average "active" Investor ... most of whom are in the "good" Funds.

>So, one should consider the average Investor. Is that your point?
Or, perhaps more relevant, the average "active" dollar.

If 99.9% of "active" dollars are stuck in "active" Funds that consistently beat the S&P, and only 0.1% are in the other, lousy Funds that consistently lose to the S&P, then ...

>Okay, I get it. But haven't you talked about this before? I seem to remember ...
Uh ... yes, about three or four years ago I wrote a (rambling) tutorial and ...

>So why regurgitate that stuff?
Because John R. pointed out a recent article in the Oct 2005 FPA Journal by Christopher Carosa that considers just that:
Compare the returns of the average "active" dollar invested in "active" Funds to the returns of the S&P 500

(Click here for the article.)

>So you believe one should invest in actively managed Funds?
I didn't say that!
It's just that somebuddy finally recognizes the holes in arguments that compare the S&P to the average Mutual Fund.
>And that makes you happy?
Well ... yes.
>Good for you.
I guess I should point out that even the asset-weighted comparison ain't that good.
Well, suppose Bill Gates invested in an active Fund that trounced the S&P and all the rest of us invested in those lousy Funds.
Then an "asset-weighted" return comparison would just tell us how well Gates did, right?
>Does Gates have that much money?
Irrelevant! The point is ...

>Yeah, I get the point. So what else? Are we finished?
Suppose I have $100K invested in a Fund which gets me -6% return.
My wife, with $1K, invests in one that get her +26% return.
If I wanted to brag about our "combined" portfolio I'd take the average return and say:
"Our family return is +10%".

On the other hand, our combined portfolio of $101K gets a return of [ 100*(-6) + 1*(26) ] / 101 or -5.7%.

On the other hand, if you wanted to know what return the average investor gets (regardless of how much they invest), you'd again take the average of these two investors: +10%.

On the other hand ...

>So if I were interested in the average return of investors, I'd take the average Fund return, right?
Uh ... no. In the case of me and my wife, there are two Investors and two Funds, but that needn't be the case in general.

>Yeah, okay. Are we finished?
Hardly ...

for Part II