Index funds versus actively managed funds, which is the better investment? This is a fair question and one that needs to be thoroughly answered. Let’s start with why people would choose to invest in actively managed funds in the first place. The simple answer is that you’re getting a professional manager who’s providing hands-on research and analysis with the main purpose of consistently beating the market. “So how’s this done?” you ask. Well, the theory goes that the professional manager, through the use of in-depth research done by themselves as well as their team of analysts, can identify opportunities in the market where stocks trade below their fair market value.
Although I do believe that pricing inefficiencies do happen in the short term, exploiting these inefficiencies is very difficult and almost impossible to do consistently. Of course, there are a handful of fund managers who are famous for their ability to beat the market (i.e., Peter Lynch of the Fidelity Magellan fund and Bill Miller of the Legg Mason Value Trust fund), but trying to find the next money manager guru is like looking for a needle in a haystack.
So the real question here is, How hard is it to beat the market? Well, for the past 15 years through 2011, the majority of actively managed funds that existed during this entire time frame underperformed the index they were seeking to beat. In summary, 84% of actively managed U.S. large-cap funds, which use the S&P (Standard & Poor’s) 500 as their benchmark, underperformed the index. As for actively managed U.S. small-cap funds, where active management should really pay off, 95% underperformed their respective index. It gets even worse for actively managed short-term corporate bond funds where 96% underperformed the benchmark they’re paid to beat.
Now you’re probably saying to yourself that active management must really earn its stripes when you invest in areas where research is limited and fundamental analysis is essential if you want to outperform an index, such as international emerging markets. Well, I’ve got some bad news for you. For the past 15 years through 2011, the MSCI (Morgan Stanley Capital International) Emerging Markets index bested 75% of actively managed emerging-markets stock funds. Not very comforting is it?
What’s even worse is that the analysis would paint an even darker picture for actively managed funds if you took into consideration the present-value tax impact of distributions. Since the majority of actively managed funds have high turnover/trading activity, this results in net capital gains that must be annually distributed to shareholders. Compare this to an index fund, with virtually no turnover, that primarily generates capital gains once you, the investor, sell the fund down the road. And as we all know, the objective is to minimize or defer taxes for as long as possible.
To better illustrate what’s at stake, let’s look at the annual expense ratios (expenses ÷ total assets) of actively managed funds versus index funds (see table 1). In addition, I’ll explain the monetary impact higher fees have on an investment portfolio over the course of a 30-year time horizon.
Just for the privilege of investing in an actively managed fund, you pay on average 1.05% in higher annual fees. On the surface that might not sound like a lot, but let’s take a closer look at what higher fees means for your portfolio. As an example, let’s say we have two separate investors (investor A, who uses actively managed funds, and investor B, who uses index funds). Both have identical portfolios of $50,000 and contribute $6,000 annually for the next 30 years at an annualized gross rate of return (before the impact of annual expenses) of 8%. Investor A would have an ending portfolio of $908,605. Not bad for 30 years of diligent investing. On the other hand, investor B would be a millionaire with an impressive $1,146,418. This equates to an additional $237,813 from using index funds that you can probably put to better use than lining the pockets of a highly compensated fund manager.
In my book, Climbing the Financial Mountain, you’ll find portfolio allocation models for every type of investor as well as recommended investments for each asset class (e.g., stocks, bonds, etc.). Each diversified allocation model is built with low-cost funds that offer above average returns, moderate volatility and very low taxable distributions.