Warren Buffett’s business partner Charlie Munger made an extraordinary observation the other day – and hardly anyone batted an eyelid. Munger, still razor-sharp at 95, was speaking on the subject of active money management.
“These index funds have come along and basically beaten everybody,” he said. “The amount by which they beat everybody is roughly the cost of running [an active management] operation. So, we’ve got a whole profession that is being paid for accomplishing practically nothing.”
I call it extraordinary observation but data has consistently shown for many years that Munger is right. Only a tiny number of active managers beat the market on a cost- and risk-adjusted basis.
What really is extraordinary for Munger is how the industry has chosen to respond to this existential crisis. Most active managers, he said, are “in a state of denial, doing what they always did year after year, and hoping the world will keep paying them for it. They have a horrible problem they can’t fix so they just treat it as non-existent”.
As Munger says, burying your head in the sand is “a very stupid way to handle a problem”. To quote economist JK Galbraith, “faced with a choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy with the proof”.
Why, then, do people continue to believe in ideas which the evidence shows are false or inaccurate?
In the case of active management, it’s mainly about financial incentives. There are large numbers of people who benefit financially from active investing. The financial media is largely paid for by active fund advertising.
But I read an article recently by self-help writer James Clear which really challenged my thinking. Truth and accuracy, Clear explains, are not the only things that matter to the human mind; we also have a deep desire to belong.
“We don’t always believe things because they are correct,” he says. “Sometimes we believe things because they make us look good to the people we care about.”
Yes, financial incentives play a part in the industry’s failure to face the facts about active management. But Clear has a point – it’s also about tribalism and the need to feel socially accepted.
Investment professionals want to be seen by their peers to be saying the right thing. But although denial may be a natural response, it’s not a professional one. It’s unacceptable for a fiduciary, who wants the best for their clients, to keep ignoring the evidence on active management.
Thankfully, there are some UK fund managers starting to break rank – Baillie Gifford, for example, with its refreshingly candid paper Riding the Gravy Train. But mostly they behave like ostriches. There’s too much to lose. And I don’t just mean their seven-figure salaries.
Robin Powell is a journalist who blogs as The Evidence-Based Investor and runs Regis Media. You can find him tweeting @RobinJPowell