The surprise announcement from PIMCO that outspoken star and CEO (and Co-Chief Investment Officer with PIMCO founder Bill Gross) Mohamed El-Erian was stepping down, created a flurry of activity for my inbox. Industry insiders opined on why he “got pushed out,” while ordinary investors wondered whether the departure of such an influential leader should prompt them to dump PIMCO funds. I will leave the former question to the rumor mill, but I am happy to address the latter one. The answer is that you should dump PIMCO funds, but not because El-Erian left: you should ditch PIMCO or any other actively managed fund because index funds are a cheaper and more efficient way to invest. Sure, there are some managed fund managers who sporadically beat the index, but the simple fact remains that it is very difficult to beat the index after factoring in costs and fees.
According to the Investment Company Institute, as of 2011, the average expense ratio for an actively managed equity fund averaged 0.93 percent, while index equity funds have average fees of 0.13 percent. It's certainly tough to beat the index when you start out the year in the hole by 0.8 percent! That's why most research has proven that over the past 40 years or so, only about a third of funds beat the index.
But even this number may be suspect - according to Vanguard founder John Bogle, the statistic ignores the fact that many underperforming funds close and as a result, some analysis treats these closed funds as if they never existed. Bogle provided Fortune Magazine with research that showed when accounting for closures, only 12 percent of funds beat the index!
I know I won't make believers out of everyone. If you still cling to the notion that the wizard behind the investment curtail holds the key to superior performance, it will take some work on your part. You need to identify active managers with a proven track record, who can consistently stick to an articulated and prudent strategy. You will also want to look for a fund that maintains low investment costs, administrative and advisory fees, plus costs due to portfolio turnover, commissions, and execution. For some, the performance payoff may be worth the time and energy necessary to find these hidden gems.
If you prefer to spend your time in other ways and want to make your investment life a little easier, there’s a simple solution: instead of trying to beat the index, just buy the index! Last year, index fund pioneer Vanguard issued a research report comparing index versus managed funds, and noted “persistence of performance among past [managed fund] winners is no more predictable than a flip of a coin…low-cost index funds have displayed a greater probability of outperforming higher-cost actively managed funds.”
Did you catch that -- a FLIP OF A COIN! For my time and money, I prefer to skip the star manager - even one as pedigreed as El-Erian - and stick to what works over the long term: a diversified portfolio of index funds.