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Index Fund Investing vs. Actively Managed Mutual Funds: Part 2

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This video shows investors that top performing active fund managers rarely repeat their past performance. 

Index Fund Investing vs. Actively Managed Mutual Funds: Part 2

In our previous video, “Index Fund Investing vs. Actively Managed Mutual Funds: Part 1”, we revealed that more than 75% of actively managed mutual funds fail to outperform the respective benchmark index.  Because of this investors are better off owning a diversified portfolio of low-cost index funds, or exchange-traded funds, that can allow you to “Own the Market” for as low as 0.05%.

Well, you may ask, “if 75% of active managers underperformed their benchmark index, why not just buy the top 25% of fund managers who did out perform their index?”

The reason, is that active managers seldom repeat their past performance.

Let’s take a look at another study to see if a fund manager’s 5 year past performance is a good predictive indicator of their future 5 year performance.

(See Video)

This graph represents all 1,509 US equity funds in the CRSP Mutual Fund Database with a complete five year performance history covering 2002 – 2006. The fund managers were sorted by their performance relative to their benchmark index.  Of the total 1,509 Fund managers, there were 377 fund managers in the top 25%.  Now, let’s fast-forward to the next 5 years, from 2007 – 2011, and see if these top fund managers continued to show up in the top 25%.  First, of the original 377 top performing managers, 55 of them did not survive the next 5 years, meaning the fund no longer existed.  Next, 175 funds, nearly half of the original 377 top funds, went from being top performers to bottom performers the next 5 years.  Next, 79 managers ended up in the bottom half of performance.  36 funds ended up in the bottom 75%.  Finally, only 32 funds, of the original 377 funds, remained in the top 25%.  Which means that 92% of the winning funds from the previous 5 years failed to produce the same winning results the following 5 years!

So what does this mean to you?  It means if your investment approach is to pick the winning managers based on their past performance, 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 fund manager had to say…

Peter Lynch, one of the greatest ACTIVE fund managers of all time who ran Fidelity Magellan from 1977 to 1990 was quoted saying,  “All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage.”

So, once again, you’ve seen the numbers, and now you know why billions of dollars continues to migrate from active managers to low-cost index funds, such as ETFs.

When it comes to choosing your investment approach remember, if you want to improve your chances for investment success, “invest in indexes, not managers”!

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