How do I get the best mutual funds?

How do you get the best mutual funds, and are actively managed funds actually worth your money?

Ask most financial advisers to recommend a mutual fund and they'll point you toward an actively managed one. The funds advertised or talked about in the media tend to be active too. But the evidence tells a very different story about whether they deserve your money.

In this video, Professor Keith Cuthbertson explains what independent, peer-reviewed academic research reveals about actively managed funds versus low-cost passive funds. After costs, active funds only very rarely outperform passive funds with any consistency. His research across the US, UK and Germany suggests around 70 percent of funds are effectively closet trackers, roughly 20 percent actively destroy value, and only about 5 percent are run by genuinely skilled managers, who he says are harder to find than the Higgs Boson.

You'll learn why advisers so often recommend active funds, why choosing them is effectively a form of gambling, and why it is almost impossible to tell whether a winning fund manager succeeded through skill or simply through random chance. Professor Cuthbertson also explains why confident, one-handed "gurus" in the media can lead investors astray, and why strong conviction, useful in some areas of life, is a liability when it comes to investing.

The takeaway: when only a tiny fraction of active funds genuinely add value, and future winners are almost impossible to identify in advance, low-cost passive investing is a far more reliable path for most investors.

Chapters / Key points

• Why financial advisers so often recommend actively managed funds
• What academic research says about active versus low-cost passive funds
• The breakdown: 70% closet trackers, 20% value destroyers, 5% skilled
• Why skilled fund managers are so hard to find
• Why it is nearly impossible to separate skill from luck
• Why investing in active funds is effectively gambling
• How the media and "one-handed gurus" mislead investors
• Why strong conviction works against you in investing

Transcript

How do I get the best mutual funds?

RP: Hello again. Ask a financial adviser to recommend a mutual fund, and chances are they'll suggest an actively managed one. The funds you see advertised or mentioned in the media also tend to be active.

And yet independent and peer-reviewed academic research has consistently shown that, after costs, actively managed funds only very rarely outperform low-cost passive funds with any degree of consistency.

Prof Keith Cuthbertson: My work, which applies partly to the US, sometimes to the UK, and also to Germany, suggests about 70 percent of funds are just closet trackers. So you're paying them a fee for something you could really do yourself. About 20 percent, your grandma could do better than them. So they actually remove value from the investment process. And about 5 percent probably are skilled managers. But having said that, they are probably harder to find than the Higgs Boson.

RP: It's hard to imagine any other industry surviving, let alone thriving, when only about 5% of its products actually work. But in fact, it's worse than that, because academics say it's almost impossible to tell whether the winners outperform as a result of skill or simply by random chance.

KC: If you put a large number of monkeys on a large number of typewriters for a large amount of time, one of them will type out "to be or not to be." But you don't necessarily hire that monkey to write your next play.

RP: When you take random chance into consideration, the number of fund managers who outperform consistently through genuine skill is even smaller. And, of course, the challenge is to identify future star performers in advance.

As Professor Cuthbertson says, investing in active funds is effectively a gamble. One explanation for why so many of us do it, he says, is that people like gambling. He also thinks the media is partly to blame.

KC: When you see gurus on the telly, I mean, sometimes people who are not that clever always sound very precise and cocksure. Whereas somebody with slightly more intelligence is always a bit circumspect, uncertain. And it's always the one-handed guru, rather than the two-handed one, who seems to win. And people, you know, put their money that way.

RP: Having strong convictions might be a useful characteristic in some aspects of life. But not when it comes to investing.