Crikey contributor Marcus Padley’s weekly columns in Fairfax usually make for an entertaining and informative read. Padley’s insights into market mentality, especially for unsophisticated mum-and-dad investors is generally on the money, but occasionally, Padley gets caught up in stockbroking or financial planning propaganda — like last week when he noted that paying a fee of 2% of an asset to a fund manager or financial planner represents a good deal. Padley noted:

I don’t know about you, but I reckon paying 2 per cent a year to have all my investments looked after, to regain every weekend and evening, let alone the hours lost at work trying to make investment decisions and trade instead of focusing on my family, my career or myself, plus being free of the everyday burden of responsibility for my family’s super fund, is probably worth 2 per cent off the average return — especially when I could drop 2 per cent in one trade doing it myself.

I would say the opposite — that charging 2% to actively invest on behalf of clients is a grotesque rip-off, especially since more often than not, active fund managers are unable to provide a better-than-market-average return. Paying upwards of one-fifth of annual profits to perform badly (and returning less than the market is performing badly) is not what we would call a great deal. That is not to say there are no talented fund managers who can provide market beating returns (there are), but rather, that across the board, active funds under-perform, and that is before their fees are considered.

Instead of paying 2% to active fund managers or financial planners, mums and dads would generally be better off placing their savings in broad index funds (depending on risk tolerance, other assets such as fixed income or cash should also be considered). Index funds effectively track the broader market and because involve no research or decision making, have far lower fees than actively managed funds (sometimes as low as one third of 1%). Most commission-based financial planners would rather drink arsenic than recommend index funds for the simple reason that index funds pay far lower commissions.

Ironically, Padley’s article, just one Buffett and its not you referred to arguably the greatest active investor of all time — US billionaire Warren Buffett. Buffett himself is perversely, no fan of actively managed funds, telling Berkshire shareholders in 1993 that:

By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.

Some fund managers have achieved the rare feat of continued out-performance — Buffett himself is one (although in recent years, Buffett’s superior performance has predominantly come from buying private businesses on lower earnings multiples rather than active stock picking), while Australia’s Kerr Neilson and Phil Matthews have delivered excellent returns over long periods. However, in most cases, most active fund managers will not perform better than the market as a whole, especially when fees are considered, but don’t expect to hear that from your friendly commission-based financial planner.