This video shows investors the difference between index fund investing and how most actively managed funds fail to beat their benchmark index.
Index Fund Investing vs. Actively Managed Mutual Funds: Part 1
So what are your options when it comes to selecting an investment approach to build your retirement portfolio?
While there may be thousands of different types of mutual funds, there’s really only two approaches to investing. There’s the “Own the Market” approach vs. the “Beat the Market” approach. The types of funds that fall into the Own the Market approach are referred to as Index funds, while the type of funds that fall into the Beat the Market approach are commonly called Actively Managed Funds, or Active Funds for short.
Although they both are mutual funds, their goals are quite different. The goal of an index fund is simple; buy all the companies in an index. For example, an S&P 500 index fund buys all 500 companies in the S&P 500 Index. The goal of Active Funds, on the other hand, is to outperform an index. They attempt this by owning fewer companies and hoping that the stocks they buy perform better than the others in the index. Reason being, it’s the performance of the index that investors use as a benchmark to measure the active fund’s success or failure.
In terms of cost, also known as the “fund expense”, active funds generally charge higher fees as compensation for the active manager’s perceived “skill” in picking winning stocks. According to Morningstar, a research firm that compiles data on mutual funds, the average fund expense ratio of all equity funds, when including all asset class categories, such as US, International, and Emerging Markets, is 1.45% annually. On the other hand, investors choosing the Own the Market approach can buy low-cost index funds, including ETFs, with an annual fund expense that could be as low as 0.05%, which is a fraction of the cost of owning an actively managed mutual fund.
Now, perhaps you’re thinking, “well, since active managers charge higher fees they must perform better than index funds!” Unfortunately, the evidence shows that the efforts of active managers are not worth their high cost. An annual study by Standard & Poor’s compares the performance of all actively managed mutual funds to that of their benchmark index. The following chart (see video) displays the percentage of actively managed equity funds that failed to outperform their respective benchmark index over the last five-years ending December 2012. The major equity fund categories include US Large Cap, meaning large companies, US Mid Cap, US Small Cap, International Developed Countries, and Emerging Markets. According to the research in the US large company category, 75% of active managers failed to outperform their benchmark index.
These results were consistent across other equity fund categories as well. 90% of managers failed to beat their benchmark index in the US Mid Cap category. 83% of managers failed in the US Small Cap category. And looking overseas, 74% failed in the International category and 76% failed in the Emerging Market category.
So what does this mean to you? It means, if your investment approach is to attempt to beat the market by picking winning managers, you may want to rethink your strategy. Active managers cannot consistently add value through stock picking and market timing. Investors are best served owning a broadly diversified portfolio of low-cost index funds!
But don’t just take my word for it. Let’s see what a legendary investor had to say… Warren Buffett, who is considered one the most successful investors of all time was quoted saying, “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees”.
So, now you’ve seen the numbers and know why billions of dollars are migrating from actively managed fund to low-cost index funds and exchange-traded funds (ETFs).
When it comes to choosing your investment approach remember, if you want to get biggest bang for your buck, “invest in indexes, not managers”! If you’re thinking, “why not just select the top managers who did beat their benchmark index”, you should watch our next video, “The Cost of Active Managers – Part 2”.
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