In honor of Financial Literacy Month, it’s time to return to a core concept of investing: the difference between a managed and an index fund. According to the Investment Company Institute (ICI), from 1990 to 2013, the number of households owning mutual funds more than doubled—from 23.4 million to 56.7 million. Given the explosion, it is amazing how many investors still do not understand the nuts and bolts of funds. Managed mutual funds rely on research, market forecasting, and a tenured portfolio manager and/or management team in order to attempt to outperform their relevant benchmarks. Conversely, index funds track the performance of a particular market benchmark, like the S&P 500, by purchasing each of the securities that comprises the index.
Of course research, expertise and the potential to generate better returns than the index comes at a price: ICI found that average fees on actively managed equity funds were 89 basis points (0.89 percent) in 2013, compared with 12 basis points (0.12 percent) for index equity funds.
Now if the pros that oversee managed mutual funds can consistently beat the index against which they are compared by more than 77 basis points every year, then you might opt to pay up. Unfortunately, very few managed funds outperform their relevant indexes.
S&P Dow Jones Indices provides biannual updates to its study, “Does Past Performance Matter? The Persistence Scorecard,” which found that not many managed funds were able to consistently reach the top quartile of performance over five successive years. In fact, less than 1 percent of funds stay above the fray for five years.
The most recent update to the research found that “as of Dec. 31, 2014, 86.44% of large-cap fund managers underperformed the benchmark over a one-year period. This figure is equally unfavorable when viewed over longer-term investment horizons. Over 5- and 10-year periods, respectively, 88.65% and 82.07% of large-cap managers failed to deliver incremental returns over the benchmark.” Mid-cap, small-cap and international managed funds also lagged their benchmarks, by 66.23%, 72.92% and 68.9% respectively.
The easiest explanation for the underperformance is the fee differential. After all, it’s tough to beat the index when you start the year in the hole by nearly 0.8 percent. But Jeff Somer of the New York Times asked S&P Dow Jones to scrub the data to eliminate the effects of fees. “Even without expenses, they found, nearly all actively managed domestic stock funds trailed the benchmarks over three, five and 10 years. Large-cap funds were the single exception, and only over 10 years.”
The myth of being able to beat the market is even more widespread in the hedge fund industry, which charges about 2 percent annual management fees as well as 20 percent of any upside profits. Last year, hedge fund annual returns were just 2.5 percent for the year, according to eVestment, a data tracker, almost 9 percent less than the S&P 500. Of course, many hedge funds are meant to act differently than the index, but you get the drift.
Optimistic investors want to believe that there’s a wizard behind the curtain, who can help them “beat the market”, but study after study finds that the simplest and most lucrative approach to investing may be the best. In most cases, creating a portfolio of low cost index funds, which are cheaper and more tax-efficient than their managed cousins, is the way to go.
Of course using index funds does not guarantee investment success. As mentioned previously in this column, even when investors use cheaper funds, they still tend to buy when markets are rocking and rolling on the upside and sell when they collapse. To prevent that buy high/sell low cycle, be sure to build a diversified portfolio – by asset class, geography, and sector – which factors in your risk tolerance and time horizon. Then populate the portfolio with index funds; and rebalance the portfolio quarterly. And pay no attention to that man behind the curtain!