By: Julio Cacho, PhD
Any decision we make balances the risks versus the reward. Investing in the stock market is no different. We pick stocks and funds based on the desired reward while weighing the potential risks. We could choose an active fund, where a fund manager tries to pick stocks that beat the market average. Or we could choose a broad-based index fund that mostly follows a known index like the S&P 500. Research shows that active funds are underperforming broad-based index funds over time. How are active managers responding? They are taking on more risk! That’s right; it’s becoming even riskier to invest in active funds.
This article, from The Economist, details how active managers are taking more risk with your money by becoming more active with portfolios. In fact, over the past decade the average number of stocks in a global active fund has declined almost 50%! Managers are now making more concentrated bets on select individual stocks for larger gains. Active managers do this because, in theory, the fund is now less like the average market index, so the gains can potentially be larger. The ones who do this correctly can potentially enjoy significant returns beyond that of a broad-based index. But those will be few and hard to find as we have talked about in our previous blogs which you can read here and here. However, buyer beware! Choosing an active fund to outperform the market also opens the door to potential larger losses. One has to consider both the risk and reward associated with this strategy.
Read this article to learn why active fund managers are taking on more risk!