What is shocking, is how catastrophically wrong you are.
"I could not care less about an active manager with a standard deviation of 10% versus 20% for the corresponding index fund that it's trying to outperform. "
For long term wealth creation, which is what you are trying to achieve, the standard deviation of returns is often far more important than the returns themselves.
Take this for a hypothetical example:
Year 1 2 3 4 5 6 7 8 9 10 Average 1 Index 15% 8% 12% 13% -25% 3% 25% 16% -30% 14% 5.10% 2 Fund 12% 5% 10% 10% -18% 7% 18% 14% -20% 8% 4.60% 3 Relative -3% -3% -2% -3% 7% 4% -7% -2% 10% -6% -0.500%
In this example:
- The fund underperforms in 7 out of the 10 years or 70% of the time (similar to your active vs passive return comparison).
- The average return of the fund over the 10 years is 0.5% lower than the index, so the fund underperforms there as well.
- But because the standard deviation of the funds returns is also lower, the compounding return of the fund is higher, and the fund outperforms the index as a result.
In finance, it is not the average return that matters, it is the compounding return.
Starting with $100 and compounding the above returns results in this:
Year 0 1 2 3 4 5 6 7 8 9 10 1 Index $100.00 $115.00 $124.20 $139.10 $157.19 $117.89 $121.43 $151.78 $176.07 $123.25 $140.50 2 Fund $100.00 $112.00 $117.60 $129.36 $142.30 $116.68 $124.85 $147.32 $167.95 $134.36 $145.11
The fund's compounding return is 3.8% versus the index at 3.5%.
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