Coin Flips and the Economics of Active Mutual Funds

Source: Thinkstock

Source: Thinkstock

I live in a small seaside town in Rhode Island. When we talk about Main Street here, we’re not talking about a metaphorical contrast to Wall Street. We actually have a Main Street. It has a shoe shop, a couple of banks, and a pharmacy with a soda fountain and some serious Norman Rockwell vibes. It also has a great coffee shop, and that’s where I am now, sitting in the corner trying to drown out the neighborhood gossip.

The manager of this coffee shop has lived here her whole life, and everyone knows her. I’ll call her Jane. Jane is one of five sisters, and she herself has three impressive daughters in their early-to-mid twenties. It’s hard not to look at this progression—two sets of women within the same family—and see something beyond random chance. Eight different times there could have been a man born, and all eight times it ended up being a woman.

But the science of genetics would tell us that the odds of eight women in a family is no different than a coin flip that happened to come up heads eight times in a row. It’s no more or less likely than any other eight-flip sequence. Rare, but it would still be likely to happen if you had 10,000 flips. Understanding this should help you with your mutual fund selection.

What on earth, you may be thinking, does this have to do with mutual funds? Well, the same concept can help us understand why we should avoid high-fee, actively managed mutual funds. First, some explanations. An active mutual fund is one that employs whiz-bang, expert analysts to try to beat the market. These funds cost more than the passive index funds that simply track indices like the S&P 500.

[caption id="attachment_713122" align="aligncenter" width="640"]Source: iStock Source: iStock[/caption]

When you’re looking across your investment options, you’ll be able to see each fund’s one-year, five-year, and 10-year performance. Some of these active funds may show higher returns than the index funds over these time frames. At the same time, investment magazines list their top mutual funds each year, which have almost always outperformed their indices in that year. Looking strictly at this data, the conclusion would seem to be that active funds rule the day.

But are we seeing real expertise at work here, or are we simply seeing the survivors of another brutal round of coin flipping? Are we seeing just Jane’s family? What these “top funds” sheets do not show are all the many thousands of mutual funds that did not perform well, or the dozens that performed well for a while, then died with a whimper. Some of these formerly ascendant funds may have been at the top of a past list, and if we bought them then—hoping for the party to continue—we would have been out of luck. And along with poor performance, we would still have had to pay the high fees.

Consider this: investors who have proven they can beat the market over decades, such as Warren Buffett, are rare enough to be household names. The rest of them, like the coin flippers, all seem to come up tails eventually.

It’s a little sad to think that neither my town nor the world’s mutual fund managers possess any kind of special magic. Eight women, eight performant years, eight tails—they’re all within the realm of the mundanely possible, and their random streak will end. Acknowledging this fact can help us move forward with our investing. Our best bet, I believe, is to invest in simple, passive index funds. These provide a smoother ride without the friction of high fees.

Picking the active, superstar funds is the equivalent of assuming that each of Jane’s daughters will themselves have a set of daughters, and on and on. It’s an amazing thought, and I’m secretly hoping it happens. But I wouldn’t bet my life savings on it.

Written by E.A. Mann. The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.  Past performance is not indicative of future results.

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