The relationship between cost and confidence

A longtime reader asked me the other day, "how do you convince someone that actively managed funds are worse than passive?" I think it's a good question, not because it's possible to convince someone that actively managed funds are worse than passive funds (it's not possible to convince people of anything, in my experience), but because answering the question highlights one of the most important relationships in investing: the relationship between cost and confidence.

All active investors get the market's return

When you buy a mutual fund or exchange-traded fund linked to a market-capitalization-weighted index, you've decided to "settle" for the market's return. Your investment will rise and fall along with the index, since the fund's holdings are linked to the market capitalization of the index's components.If all passive investors get the market return, then by definition all active investors also get the market return, minus trading costs, since active investors are trading against each other: each active investor's winning bet is another active investor's losing bet, minus trading costs on each side.

Good active management is cheap at any price

If you knew your active fund manager was going to beat the market indices by as little as 1% per year, after taxes and fees, you should be willing to pay virtually any amount for their services. Over long enough time horizons, even modestly higher investment returns result in enormous increases in the final value of an investment.

I know of no way to identify good active management in advance

After the fact, all the people who selected "good" active managers will end up much richer than all the people who selected "bad" active managers. But as an investor, your task is not to identify who outperformed in the previous 10, 20, or 30 years, which you can easily look up online, but who will outperform in the next 10, 20, or 30 years.As if that weren't unfair enough, over the course of their careers active managers move from fund to fund, and eventually leave the business, one way or the other, so the benefits of correctly identifying the best active manager have a built in time limit, whether it's retirement or the grave.

How many times do you have to be right?

Passive, market-capitalization-weighted index funds don't absolve you of the responsibility, or consequences, of investing your money well. If you invest in Vanguard's Total Stock Market Index Fund instead of the Vanguard Total International Stock Index Fund, and the latter outperforms the former, then you made the wrong choice and performed worse than someone who made the opposite choice.But when you pay an active mutual fund manager to decide, over and over again, which stocks to buy and which to sell, you're not just counting on that person to be a better stock picker than you are. You're counting on that person to be enough better a stock picker than you are to make up for the management fees you have to pay them whether or not they outperform.When you know, by definition, that all investors in actively managed funds will underperform all investors in passively indexed funds, due to the higher fees charged by actively managed funds, the core question becomes clear: no matter how good you are at picking active managers, how many times do you have to be right to make up for all the fees you have to pay whether you're right or wrong?When you're wrong, you pay higher management fees and underperform. When you're right, you pay higher management fees and outperform. How sure are you that your excess returns will exceed your excess losses? It appears to me that there is no evidence whatsoever that individual investors have any capacity to select skilled active managers even once, let alone over and over again throughout an investing lifetime.So I choose to invest in passive funds, because I think the amount I save in management fees is greater than the amount I could realistically squeeze out of a lifetime of hopping from one expensive actively managed fund to another.But if a Wall Street Journal from 2048 fell into my lap, I'd happily change my mind!