If you believe that active investment management can provide returns in the long-term that will surpass the market averages, then here are some straightforward thoughts to always bear in mind:
Keep your transactions costs and fees low. As Jack Bogle, founder of Vanguard and the strongest proponent of indexing, has stated, the most important factor affecting long-run total returns is not whether you should hold index funds or active funds, but instead the focus should be on low cost versus high cost funds. The general rule, that has considerable academic empirical support, is that lower cost funds tend to generate higher total returns than more expensive funds over time.
It should be noted that this rule tends to apply to all investment categories – regardless of whether a fund is indexed or actively managed. As stated in the online course: Introduction to Applied Investing, over time most Vanguard index funds have outperformed the majority of active funds when total returns (net of fees) are considered.
Have patience if you are using active managers. If you are going to use active funds (with reasonable fees and a solid investment process) then you need to be aware that over the long-run (say 15 years), a majority of these funds will suffer at least one stretch of three consecutive years of under-performance during that period. Investors who follow a simple sell baseball rule of “three strikes and you are out” would have erred. Almost all active funds will have a period where they lag their benchmark or more the top half of their peer group. Again, a sensible strategy of staying with an active manager over a reasonable time period – rather than chasing returns – is more purulent than dropping under-performers in the short-term.
Set flexible sell rules. You can’t be expected to stay with a sub-par performer forever – so how do you know when to fire a fund manager and more on to another? Something that triggers a sell for me is if there is a higher than normal turnover rate of the fund’s managers and analysts. If there is high turnover, you are probably looking at a fund that is having difficulty maintaining its strategy over the long-term. Successfully managed companies (in any industry) tend to have stability within their organization – and mutual funds are no different. You should consider a rule that sells an actively managed fund that has weaker than average total return performance, an inconsistent investment strategy, and a high employee-manager turnover rate.
There are many capable and strong active managers. You need to be smart in selecting them and patient in evaluating their performance – be careful not to chase returns. That’s refereed to as a loser’s game!