I ask every new client a lot of questions during our first two meetings. I gather a lot of information, facts, figures and perceptions. Information is critical to helping investors achieve their financial goals.

One of the highest questions on my list is “how do you invest your money?” Most commonly I hear:

• I don’t know I don’t really have a method, or
• I use Morningstar ratings, Forbes Honor Roll, Money Magazine (and on and on) to pick mutual funds.

Every once in a while an investor comes up with something more unique, like “I pick stocks with high dividends” or “I subscribe to Snappy Joe’s investing newsletter”. Most often however, investors either don’t have a strategy or they pick mutual funds based off of some rating service or publication.

Investors who don’t have a method have bad investment portfolios. Investors who use Morningstar ratings, the Forbes Honor Roll or Money Magazine recommendations typically have horrible investment portfolios. Sometimes the difference from “bad” to “horrible” is thousands of dollars per year (or more) in expenses and poor investment returns!

Method #1 is just plain crazy! Why would you put a single dollar at risk without a great investment plan? You’re NUTS!

Method #2 doesn’t seem as crazy. but usually produces worse results. Why would investing in highly touted mutual funds be so bad?

Simple answers are sometimes incredibly difficult to understand. It boils down to “past performance is no guarantee of future results” (very cliche right?) Moreover, those stellar past returns are often a prognostication of future abysmal returns!

Weird right? You’d assume if the fastest car is a Ferrari this year, it’s going to be the fastest car next year (or at least close to the fastest car). This isn’t the case with investments however, the best rated funds this year are often next years worst performer’s.

Ferrari’s turn into Cadillac’s, Toyota’s and Pinto’s. You may be OK with the Cadillac, but the odds are far higher you’ll get a Toyota or Pinto.

This is the main reason we review our recommended mutual funds and ETF’s each quarter. We keep a close watch on our investments, we recommend you do the same!

But what if you could drastically increase your odds of owning Ferrari’s and Cadillac’s consistently? You can, it’s not as hard as it sounds. You just have to start with the mutual funds and ETF’s that are consistently Ferrari’s and Cadillac’s.

Your mutual funds and ETF’s should be:

• Ultra low cost. Mutual fund and ETF fees and expenses directly reduce your investment returns. Ferrari’s and Cadillac’s have expenses consistently in the lowest quartile when ranked against their peers. They’re not just low cost, they’re ultra low cost!
• Consistent in strategy. Mutual funds and ETF’s which have a consistent investing strategy will help ensure you enjoy more consistent investment results.

It seems simple on the surface, and I’ll be the first to admit it’s not rocket science. Unfortunately not every investor understands those two core concepts. To give you a “leg up” with investing, let’s look at the differences between active and passive investing and how low fees and consistency affects your investments.

First off, there are two main “styles” of mutual fund and ETF management: actively managed and passively managed. There’s a third strategy some would say is it’s own style which is index tracking. I prefer to think of index tracking as a subset of passive management however.

Let’s look at the specifics of each style assuming index tracking has it’s own category:

• Actively managed mutual fund investing. Actively managed mutual funds and ETF’s have a manager (or team of managers) who is actively engaged in generating as much investment return as possible. They do this through various stock or bond picking, trading and timing strategies. The investment expenses are much higher because they hire high priced managers with fancy pedigrees to run the portfolios. Their strategies are also far less consistent, because they pick securities and time the markets as they see fit. Actively managed mutual funds and ETF’s are higher cost and more inconsistent investment options when compared to their passively managed and index tracking counterparts.
• Passive (or asset class) mutual fund investing. Passively managed mutual funds and ETF’s are 180 degrees opposite from their active management counterparts. Passive strategies DO NOT attempt to beat the market, rather they seek replicate the volatility and returns of a specific asset class. Unlike actively managed funds, passive mutual funds and ETF’s may own ALL stocks in an asset class like all US large cap stocks, or all US investment grade bonds basically they own large quantities of similar securities with complete disregard to any individual security. They do not time the market, trade securities like they’re going out of style or claim to “beat their benchmark”. Passive investment strategies simply settle for the returns of a specific asset class. This keeps fees and expenses very low since there are no big marketing budgets or high priced fund managers. This strategy also provides much more consistency in fund performance since the strategy isnt subject to the whims and fancies of a pedigreed fund manager.
• Index Fund Investing. Index fund investing is a “form” of passive investing, though some advisors may argue it’s it’s own category or style. Most investors use the two terms “passive” and “index” interchangeably, however they’re not synonymous. Index mutual funds are designed to mirror or track a specific index (such as the S&P 500 or MSCI EAFE). Their goal is to deliver investors the total investment return of an index minus fees and expenses. It’s important to note index funds are always tied to a specific index, and they must adhere to that index’s rules. If the index adds a new stock, the index fund must do so as well. If they index sells out of a stock, the index fund must do so as well. While index funds are very low cost and follow a consistent strategy they have some drawbacks as well which we’ll discuss in greater detail later.

Actively managed mutual funds and ETF’s buy and sell securities based on market timing, momentum, earnings reports or news stories. They sometimes have trading programs and sophisticated software, they sometimes trade off their gut instincts.

Passively managed and index tracking mutual funds and ETF’s accept the returns of the index or asset class. They never select or trade securities based on strategy, and they certainly never time the markets. They just own a whole lot of highly similar securities in one mutual fund or ETF.

If keeping expenses low and having consistent performance is the goal, passive and index tracking strategies are far superior than actively managed funds. There are other problems with active management however.

Active managers DO NOT have the “secret sauce” for superior investment returns. They DON’T know better than the next guy. They CAN’T consistently “beat their peer group” or “beat the market”. In fact if it’s just higher than average performance you want, passive and index tracking methodologies have that too!

Take a look at the top 25% of US equity funds. These are the “cream of the crop”! The “best performers” the funds everyone wanted to own! 

The numbers are proof enough. The best performing mutual funds should be used more to predict POOR performers rather than TOP performers! Only 8% (the Ferrari’s) of the top performers from 2001 2006 managed to achieve the same top quartile of performance the subsequent 5 year period. A whopping 67% of the “top performers” found themselves in the bottom half of performance (Toyota’s and Pintos).

This isn’t data mining. I’ve seen this study and other similar studies performed over and over during my 18 years working with clients. The results are always the same, the top performers tend to fall off the map over time. The funds get too big to manage, the managers specific strategy falls out of favor, or their luck just plain runs out.

What’s worse is 55 of the mutual funds didn’t even make it through the next five years! They were so bad in fact that the fund managers either closed them or merged them into another mutual fund.

When poor performing funds are closed or merged it skews the results for all remaining mutual funds. The results for other funds look better than they are because the sample size is smaller. It’s called “survivorship bias”, meaning that mutual funds which survived get a bias because they look better than they actually were, just for not being closed!

When you account for survivorship bias the argument for actively managed mutual funds becomes even weaker. Only viable (good or decent performing) mutual funds will continue to stay alive. Poor performance, high fees and excessive turnover creates shareholder discontent and withdrawals. When a mutual fund can’t survive it gets wiped off the map!

Survivorship bias makes it even more difficult to see what an advantage passive investors truly have. Passive mutual funds must compete against better mutual funds because the horrible ones disappear! If you consider all mutual funds (even the ones that died), passive investment management is far more superior!

If you’ve ever picked mutual funds from a rating service, chances are high they were actively managed mutual funds. There’s also a good chance the rating service was Morningstar. They’re by far the most commonly used rating service today.

According to their own website: “The Morningstar Rating, most commonly referred to as the ‘star rating’, is a purely quantitative, backward-looking measure of past performance. It is based on a fund’s risk- and cost-adjusted performance over three-, five-, and 10-year periods and helps investors to quickly and easily assess a fund’s track record relative to its peers”.

At Morningstar’s 2010 annual investment conference, Don Phillips, President of Fund Research at Morningstar stated: “The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future”.

Of course they can’t predict the future. Unfortunately I’ve seen hundreds of investors over the years select funds based on Morningstar ratings. Apparently most investors didn’t get the message from Morningstar.

Using rating services (Morningstar, Forbes, Money Magazine, etc.) is like driving your car while looking through the rearview mirror it’s going to cause a lot of accidents!

If I gave you a trick quarter which landed on heads 70% of the time would you bet on heads or tails? You’d obviously bet on heads. You wouldn’t be reading this book if not. In fact you’d likely be enrolled in gamblers anonymous.

If you want performance here’s your trick quarter. The overwhelming majority of actively managed mutual funds fail to beat their benchmark.

Want proof? Let’s look at bond funds first:

And when it comes to equity investing the results aren’t much different:

Looking at the data ended 12/31/2012, out of the 15 stock and bond investment styles, 70% of the time actively managed mutual funds can’t beat their benchmark index. I could produce datapoint after datapoint backing this up in various ways.

The results speak for themselves. Active management is a loser’s game.

Statistically there will always be some actively managed funds which will outperform their peer group or benchmark. The problem is there is absolutely no way to know which ones will do so in advance of them actually outperforming.

Active management outperformance is nothing more than randomness. If you want to be successful, you should never try to predict randomness its random for a reason!

Actively managed mutual funds and ETF’s have higher fees and lower consistency. They also fail horribly at beating their benchmark index. This begs the question “why would anyone invest in an actively managed mutual fund and pay astronomically higher fees to reduce their investment returns?”

By and large most investors don’t understand the differences benefits and disadvantages between active and passive investing, yet the decision to invest actively or passively is an important one. Every investor should be well educated in both styles of investing and understand that index tracking is simply a form of passive investing.

So forget about honor rolls, star ratings, and every other fund touting service out there. Turn off the noise and start by keeping it simple. You already have your trick quarter, simply invest wisely!