Stocktake: Why do investors still buy active funds?

Active funds invariably underperform, so why do investors still bother with them? A recent paper by Israeli academic Prof Moshe Levy, The Deadweight Loss of Active Management, estimates only 13 per cent of active US funds outperform.

That results in huge aggregate annual losses – $235 billion – to investors.

Passive index funds have grown enormously in recent years, but the active fund industry remains “huge”. Active US domestic equity funds managed $10 trillion in 2021, compared to $2 trillion in 2000.

Indeed, the proportion of equity holdings in active funds increased from 8 per cent in 1985 to almost 20 per cent in 2017, says Levy.

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Returning to the “why?” question, Levy blames “systematic cognitive biases” exploited by funds’ “highly motivated” marketing teams. Funds advertise their best-performing funds, not their underperformers. Additionally, they use an incubation strategy: privately starting several new funds and eventually shutting down those that did poorly and making public only those who did well.

Consequently, many investors erroneously conclude most funds outperform the market. Additionally, overconfidence makes investors over-estimate their ability to select tomorrow’s winning funds.

Levy recommends making index funds the default choice in retirement plans and adding to regulatory disclaimers the statement that active funds usually underperform indices. Passive funds keep growing but so do active funds.

There is, says Levy, “a long way to go”.