Investors often opt for actively managed mutual funds or ETF’s as a way to “beat the market”. Occasionally, over short spells, they may in fact beat the market. But these forays into managed funds can also increase risk. That then begs the questions: should you invest in actively managed funds and attempt to get higher returns? Or should you stay with index funds and be content to reliably track the market?
It’s close to a myth that actively managed funds outperform index funds. According to a recent study, index funds outperform managed funds as much as 90% of the time.
A complication — or perhaps a distortion — occurs because there are times when an actively managed fund can outperform the market, at least for short periods of time. However, reality and statistics clearly show that very few actively managed funds will outperform index funds for more than one or two years.
The higher performance could also be a result of a fund that holds large positions in a small number of companies that are performing at well above market averages. But once the growth curve on the high-flyers slows, performance of the fund is back to normal, and may even begin underperforming index funds.
There is a flip-side with actively managed funds that most investors don’t give much thought to, at least not when they are buying in. Everyone buys into a fund under the optimistic assumption that it will outperform market — if they didn’t, there would be no point investing in the fund at all.
It’s fine if the fund at least keeps pace with the market, and especially if it outperforms it, but what happens if the actively managed fund begins to under-perform the market?
There is probably no single factor that so upsets an investor as holding an investment that is underperforming the market. Index funds will always perform consistently with the market; but an actively managed fund has the very real potential to under-perform it.
How would you feel paying a professional fund manager to under-perform the market? That is a very likely outcome if you are investing in actively managed fund.
One of the very best reasons to invest in index funds is that you can choose your investments and forget about them. This is as it should be, after all you have your life to live and a job to do that probably has nothing to do with the stock market. Index funds make it easier for you to tend to your business, rather than worrying about what you have your money invested in.
If you choose to go to actively managed funds, you’re going to have to do a substantial amount of research. This will go beyond simply looking at the fund’s performance the past few years. You’ll have to be concerned with the fund managers investment philosophies and whether or not they match your own.
You’ll also have to be concerned with holding positions in funds that may be at least somewhat out of sync with the general market. If the fund is invested heavily in positions that are counter to the general market, you have to be comfortable with the potential for those investments to go in the wrong direction.
If you invest primarily or entirely in index funds, none of that will be a concern.
Actively managed funds incur significant transaction fees due precisely to the increased activity. This is especially true if the fund is a high turnover fund, which means that there is a portfolio turnover rate in stock holdings that exceeds 100% per year.
Index funds on the other hand tend to be fairly static when it comes to turnover. A change in portfolio holdings will generally only occur if there is a change in the securities represented in the index that the fund is tracking. For example, if you’re investing in an index fund that is tied to the Dow Jones Industrial Average, stock turnover will mostly occur when the Dow removes one or more companies from the average, and adds others to replace it.
On an annual basis, the additional fees from actively managed funds might amount to no more than 1%. That may seem as if it isn’t much, but it could reduce the average annual return on your investment from say 10% to just 9% — remember, there’s no evidence that actively managed funds outperform index funds to make up for the higher fees.
Over time, that 1% difference in investment return could add up to something substantial. $100,000 invested at 10% for 30 years will result in a $1,744,940 portfolio. The same amount invested for 30 years at 9% will result in a $1,326,768 balance.. That’s a difference of well over $400,000 over 30 years – just from a 1% difference in investment fees!
For most people, index funds will be the best way to invest in the stock market, at least with the majority of their portfolios. While your 401k or 403b may not offer index funds, some employer plans include them and you can certainly invest in index funds if you manage your own Roth IRA, IRA, or personal/brokerage account.
What do you think of index funds? Are they the best funds for most investors? Feel free to disagree!
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