As an investor, I hear this all the time: “just put your money in index funds, most fund managers can’t beat the market anyway, so why spend money on their expensive fees?” If you are interested in investing chances are you’ve probably heard that too.

To tell you the truth, I do believe this advice and I personally allocate a large portion of my portfolio to index funds. However, I never really understood why. I mean, fund managers do this for a living. Full time. Every day. Is it really this hard to beat the market? Is it impossible to perform better than index funds?

So I did a little research and what I’m going to share with you is my take on what Joel Greenblatt says in his book “The little book that beats the market” about this. He, as most of you will know, is a hedge fund manager and knows this industry in depth.

In his book he explains a little bit about the industry, how mutual funds and index funds work. He then explain some of the reasons why most fund managers don’t beat the market. I must say that being a fund manager must be a really hard job and I really respect those professionals.

So here is what I’ve learned from Joel Greenblatt on why most fund manager don’t beat the market:

1- Most mutual funds charge fees and expenses based on the size of the fund – usually 1 to 2% of the total assets. This means that the more assets, the more money the company makes. The goal of mutual funds is therefore to manage large amounts of money, which will increase the amount they earn in fees.

 

2- There are a lot of great returns to be had in smaller companies and there is not usually as much research done on them, so less investors will know about them. 

However, funds with large amounts of money (their goal) often can’t take advantage of those opportunities. That is because there are rules about the percentage of stocks in a company that a fund can own. They can’t allocate an amount of money that works for the fund to a small company without owning too much or pushing the price up.

 

3- You might be wondering – can’t they just invest small amounts in those smaller companies? And the answer is no. Most funds already own between 50 and 200 stocks. They would have to own A LOT more stocks to be able to do that, and it becomes impossible to actually analyse in depth the value of each company. Some will be valued effectively, but not all of them.

Those funds are already diversifying, which is a good thing as bad stocks won’t influence the portfolio so much, but good stocks won’t either.

4- It is good that they are diversifying, because funds can’t be too far off the market average without losing clients. This means they have to be very careful about more risky opportunities.

 

In the end it is easier for funds to buy smaller sized positions in larger companies – which will be likely similar to companies in index funds.

When you consider all this, it really does make sense why most fund managers don’t beat the market. This is not to say they no one will, but their job is really hard, and most won’t.

I’m sure this list does not fully cover why most fund managers don’t beat the market, but Joel Greenblatt gives the reader a pretty good idea of how things work.

What are your thoughts on this? Have you read any of Greenblatt’s books? Would love to see them in the comments below.