This Is Your Single Biggest Investment Mistake

I'm not going to make you wait for the punch line. Your single biggest investment mistake is owning any actively managed funds. That's where the fund manager, through stock picking and market timing, attempts to beat the returns of a designated benchmark, like the Standard & Poor's 500 index.

I started writing books and blogs about investing in 2006. At that time, only a very small minority of people invested in index funds. Jim Cramer was at the height of his popularity.

I struggled with different ways to communicate to investors that the only intelligent and responsible way to invest was to capture the returns of the global market. This meant investors should avoid stock picking, reject market timing and not engage in the fruitless attempt to pick the next "hot" mutual fund manager. The general reception to this message was about the same as you would expect watching a vegetarian lecture to a cattlemen's convention. The common objections were:

-- "I don't want to settle for 'average' returns."

-- "My broker and I can 'beat the market.'"

-- "I only invest in companies I know."

-- "I can beat the market using dividend-paying stocks."

-- "If you are right, that means everyone making predictions in the financial media is wrong."

Though these assertions may have surface appeal, none of them withstand scrutiny, despite the messages pushed by the mutual fund industry and much of the financial media. The passage of time has been accompanied by a seismic shift in investor attitudes. The dismal track record of actively managed funds has caused even leading proponents of active management to throw in the towel.

Morningstar describes itself as a leading provider of independent investment research. One of its best-known products is its star rating system, which rates mutual funds from one to five stars, based on how well they performed (after adjusting for risk and accounting for all sales charges in comparison with similar funds).

Although Morningstar has cautioned investors to make expense ratios (the management fees charged by mutual funds) a "primary test in fund selection," many investors ignore this advice and use star ratings instead. The mutual fund industry encourages this practice by touting the star ratings of its best-performing funds.

Given Morningstar's preeminent position as a provider of information about actively managed funds, it was startling to read the views of John Rekenthaler, the company's vice president of research. In his blog post, Rekenthaler reviewed net sales over the past 12 months for all exchange-traded funds, passive mutual funds and active mutual funds. He found 68 percent of those sales went to passive investment products. Rekenthaler concluded that passive investing is now the mainstream approach and that "active managers have become the periphery."

The message that actively managed funds typically do not add value to investors is resonating globally. A report issued by the Pensions Institute in June 2014, "New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods," based at the Cass Business School of City University in London, reached some startling conclusions.

Researchers examined the returns of 516 stock funds based in the United Kingdom for the period from 1998 through 2008. They found only 1 percent of fund managers produced returns sufficient to cover trading and operating expenses.

In my prior experience, even this data may not dissuade many investors. They would tell me that, with the assistance of their broker, they had the ability to select and purchase that tiny percentage of outperforming actively managed funds. The report by the Pensions Institute dealt a death blow to this claim.

First, it found that prospectively identifying the minuscule number of outperforming fund managers is "incredibly hard."

Second, the report noted it takes 22 years of performance data to have a high degree of confidence that a fund manager's outperformance is a product of skill rather than luck.

Third, it found the tiny group of "star" fund managers able to generate superior performance in excess of operating and trading costs were the sole beneficiaries of their skill. They extracted "the whole of this superior performance for themselves via their fees, leaving nothing for investors."

Perhaps the cruelest cut was that researchers concluded the vast majority of underperforming fund managers were "genuinely unskilled," not simply unlucky. Here's the good news. It's disarmingly simple to avoid making this critical investment mistake. The first step is replacing your actively managed funds with low management fee, comparable stock and bond index funds, passively managed funds or ETFs.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."