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Oct. 24, 2020, 9:36 a.m. EDT

Why those highly paid investing pros do worse than a 401(k) committed to a boring stock index fund

High fees take a toll on performance, no matter how bright and brilliant you are

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By Michael Edesess


Getty Images/iStockphoto

Most investors would say that professional investment managers must get a higher return on their investments than ordinary Joes, because they’re smart and have much greater knowledge and better investing tools.

Then why is it that the investment managers with the most certifiably impressive credentials don’t do better — in fact they do worse — than the ordinary Jane or Joe?

If you don’t believe that, let’s look at evidence recently published in the Journal of Portfolio Management by Richard M. Ennis, a long time consultant and expert in the field who ran one of the most highly respected consulting firms to institutional investors and was the editor of the respected Financial Analysts Journal.

The educational endowment funds of top universities including Harvard, Yale, Princeton and Stanford are gigantic pools of money that are used to fund university research and student scholarships. The largest ones each have more than $25 billion in assets . Other top-rated universities have endowments in the multiples of billions too.

Their assets are invested in stocks, bonds, and other investments. They are managed by highly qualified and well-paid experts who have access to professors in the finance departments at their universities, which contain renown academicians in the fields of finance and economics, many of them Nobel Prize winners. Because of their large size and the connections of their managers and university contacts, these funds are able to invest in investment vehicles that are not available to ordinary investors.

Wouldn’t you think that these funds would achieve better investment results than, say, a middle-class worker whose money is invested in her 401(k)’s low-cost index fund?

But they don’t. In fact, as Ennis’s research shows, they achieve worse results.

Why? Because they pay higher fees to their investment managers than the middle-class worker does. Their shortfall in investment performance is almost exactly equal to the excess fees they pay.

Endowment fund managers try too hard and pay too much.

Trying to achieve excess performance — as anyone might think they could do, and as they are paid to do — these endowment fund managers try too hard and pay too much. Particularly in the last dozen years or so, they have outsourced the majority of their money to arcane investment assets including hedge funds and leveraged buyouts — the kind that aren’t available to the 401(k) investor.

To invest in these so-called “alternative” investments, you have to pay higher fees. According to Ennis, large endowments pay on average a steep 1.6% annual fee — exactly the amount by which they underperform the middle-class investor’s 401(k) index fund.

Read: What the Harvard endowment’s below-average grade can teach you about index funds and your investments

How can all that expertise and brilliance not achieve a better return on investment?

The answer is surprisingly simple: Consistently getting a better-than-average return on investment requires that you can constantly know things about the future that virtually no one else can know. There is only one possible way to do this; it’s available only rarely to a few individuals, and it doesn’t even always work so well. It’s called insider trading — and it’s illegal.

Other, legal methods of trying to get a better return on investment don’t work at all, no matter how brilliant they and their practitioners are. The mathematical methods of the finance field don’t help one bit, in spite of the fact that academic journals of finance are awash in it, one could accurately dismiss it as being all for show.

The trouble is, because ordinary investors don’t understand that it is all for show and no actual use at all, they are inveigled by snow jobs sold to them by purveyors of investment schemes that are meant to make ordinary investors believe they are “sophisticated,” and therefore will do better.

‘Smart beta’ fails

The latest incarnation of this game has been marketed as “ smart beta .” The selling of it has been highly successful — smart beta investing is a trillion-dollar industry of funds sold mostly to the relatively small investor.

How have they done? Terribly. In the past decade or so since they were introduced and marketed, smart beta funds have substantially underperformed a total market index.

In 1972 the journalist David Halberstam published a landmark non-fiction book titled “The Best and the Brightest.” It chronicled how the foreign policy academics and intellectuals who were, indeed, considered “the best and the brightest” careened into the terrible mistake that was escalation of the Vietnam War.

It can be a mistake to put too much faith in expertise. In the investment management field, this truth is spectacularly apparent.

Michael Edesess is chief investment strategist at mobile financial-planning software company Plynty and a research associate at the EDHEC-Risk Institute. He is the author of “The Big Investment Lie” and co-author of “The 3 Simple Rules of Investment.”

More: Ivy League colleges shun Warren Buffett’s advice

Plus: Vanguard opposes a tax on Wall Street its founder John Bogle favored — and the reason may surprise you

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