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Active And Passive Mutual Funds: Which Is Better?

When it comes to mutual funds and performance, there is probably no bigger argument in the financial industry than whether investors should buy actively or passively managed mutual funds. Actively managed mutual funds pick specific stocks each year that the mutual fund managers think will outperform the rest of the market. Passively managed funds just follow the same rule year after year and buy and hold a set basket of stocks that is specified in their prospectus. This might be the entire S&P 500, or some specific sector like a basket of all healthcare stocks.

So the debate essentially comes down to whether or not mutual fund managers broadly have skill in picking stocks, or if any outperformance by their fund in a given year is just random luck. Financial economists have spent a lot of time looking at this question and the basic conclusion from most researchers is that most mutual fund managers can't outperform the market after you take into account both the fees they charge and the "risks" of the stocks they choose.

So what this means is that most managers who outperform the market either outperform because of luck, or because they choose stocks that have higher levels of "risk" than the average stock in the market. Now whether these so-called risks are in fact capturing risk is open to debate. For example, a common mutual fund strategy (and hedge fund strategy) is to go long stocks that have a high degree of price momentum. Momentum, or the amount that a stock has risen in the recent past, is a risk in most financial economists model, but most individual investors wouldn't view it as a risk at all. The point being that even if managers are outperforming their benchmarks by choosing stocks with certain "risk" characteristics, like momentum, the average investor doesn't care as long as the price is no more volatile than the overall market.

However, there is another major result that has come from the statistical analysis done on mutual fund returns. While most funds can't consistently outperform their benchmark set of stocks (or passive funds that track those benchmarks) after taking into account risks and their higher fees, there are some funds that consistently underperform the benchmarks. Funds that underperform tend to keep underperforming!

It's also pretty well known that mutual fund investors tend to chase returns. Investors move from one fund to another based on which managers have had a good (or lucky) quarter or year. Yet they don't tend to leave the underperforming funds. This could be because they are locked in by fees for exiting the fund, or because they are hoping the fund will eventually turn around. Whatever the reason, it's ironic that investors chase mutual funds with good returns, most of whom are probably just lucky in any given year, but they fail to run away from funds that are consistently poor performers.