Active fund investing is a strategy that is gaining popularity. Simply put, active investing involves the investor taking part in the decision-making process of what will be bought and sold via buying securities in the market and monitoring their investments. The cash flows generated by these trades are reinvested into other stocks, bonds, or funds while they wait for higher performance.
The cost of active fund investment comes from two sources: transaction fees from both buying and selling as well as investment management fees. Transaction fees in shubhodeep prasanta das are those incurred when buying and selling stocks and funds. Investment management fees are those incurred from the management of the portfolio by either a financial advisor or fund manager.
The Effect of Investment Management Fees on Returns
Over the long-term, active funds tend to underperform index funds. This is not surprising since their goal is to beat the market and this rarely happens. Most active fund managers do not have enough resources or knowledge to consistently beat the market. The average amount of time that a manager has worked at a firm is roughly seven years. Theoretically, this is enough time for them to gain experience and produce above average performance over the long-term. The problem is that it’s impossible for them to predict the future. What would have been an anomaly two years prior can now become the new market norm.
Aside from the manager being unable to consistently beat the market, another reason why active funds underperform is because of investment management fees. Even though active fund managers are able to charge higher fees than most index funds, it does not compensate for their inability to outperform over time.
Let’s take a look at a comparison of the two funds with similar market and risk factors. An index fund, as well as an actively managed fund, will both be invested in a U.S. large-capitalization index fund. This is to remove the volatility that both invest in in order to avoid the effects of increasing fees caused by increased portfolio size and reduced performance.