Winning 'Active' Funds Don't Exist, Ferri Says

NEW YORK (TheStreet) -- When it comes to investing, don't even try to beat 'em, just buy index funds and join 'em, says author Rick Ferri.

In his new book, The Power of Passive Investing, Ferri says the probability of a single actively managed fund beating a comparable index fund over any single year is 42%. He adds that the success rate drops to 30% over five years, 23% over 10 years and only 12% over 25 years.

And here's some more bad news for investors with actively managed funds: The odds get progressively worse as more active funds are added, Ferri says. Assume you own 10 actively managed funds. The odds of beating an all-index-fund portfolio are 27% over one year, 9% over five years, 6% over 10 years and 1% over 25 years, he says.

So why would an individual investor brave those odds and choose actively managed funds over a low-cost index fund? It's all about the marketing, says Ferri, who manages money and has co-written six investment books including The Bogleheads' Guide to Retirement Planning.

"Wall Street is full of promises. Companies that actively manage mutual funds promote their products based on the perception that they're staffed by very smart and informed people and that they'll earn higher returns than the markets. What investors don't see, and most don't consider, is the academic facts proving that most funds don't achieve this goal."

Ferri asserts that actively managed funds on the whole underperform their benchmarks by the fees they charge, which generally range between 1% and 2% for stock funds. His solution is an asset allocation of low-cost index funds or exchange traded funds, which charge as low as 0.10% to track an equity index such as the S&P 500.

As for skeptics who say that even index funds didn't survive the 2008 crash in stocks, Ferri says risk control through asset allocation and rebalancing can't protect a portfolio every year, but it will help smooth the bumps.

"When money flows out of risky assets, it typically flows to safer assets such as bonds. Treasury bonds had a very strong year in 2008, and then everything reversed in 2009," says Ferri.

As to which fund family has the best index funds, Ferri says Vanguard has traditionally offered good ones, but the recent ETF pricing war is bringing others into view. And no matter which index fund you choose, he says it's much better to bet on the benchmark than the fund manager seeking to beat it.

"The naysayers of index funds argue that there are ways to select winning active funds in advance, and this makes active management a winning bet. Seeking alpha with a winning mutual fund method would make sense if one existed, but it doesn't. And even if such a method did exist, it would stop working rather quickly as millions of investors pile into the same winning active fund and handcuff the manager with billions of new dollars to invest."

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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