Why We Don’t Use Active Funds

admin Financial Life 201

We’ve never believed that “actively managed” investments can reliably outperform index funds over longer-term timeframes. (NOTE: when we use the term index funds, we mean mutual funds and Exchange Traded Funds (ETFs).) Turns out, the evidence is on our side: over the past decade, the vast majority of actively managed funds – large-cap, mid-cap, and small-cap alike – underperformed their benchmark indices (source: S&P Dow Jones Indices, SPIVA 2014 Year-End Scorecard). See also Prof. Burton Malkiel, A Random Walk Down Wall Street: the Time-Tested Strategy for Successful Investing; John Bogle, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor.

Given actively managed funds’ underperformance, why do they cost so much? Interestingly,  it is those extra costs associated with active management that end up being the main reason for their long term underperformance when compared to a benchmark index, which is one of Bogle’s main points.

Some of the extra cost goes for research, the goal of which is to pick stocks that will do better than the aggregate investment result of the stocks in the benchmark index. Then there are the trading costs that arise when stocks are bought and sold by the fund managers. Taxes on gains also add to the cost of owning the fund. Some funds add their own distribution costs to the fund, paid by the investors. And sometimes there are sales commissions, referred to as “loads,” paid to brokers for selling the funds, which would add another cost.

By comparison, the investor in an index fund pays a very low fee to the fund, which does no research, has few trading costs and few taxable distributions, adds no distribution costs, and has no loads. The index fund invests in all the stocks that meet the definition of the index the fund has developed (e.g., various emerging market indices), or invests in an existing index the result of which the fund is designed to match (e.g., the S&P 500 index). There is no picking and choosing of certain stocks to the exclusion of others, within the universe of stocks in the index.

Over time, many in the investment community have come to realize that all the smart people, and sophisticated strategies, trying to pick the outperformers adds up to an exercise in futility. We think the better approach is to buy all the stocks in the various sectors of the markets that you are interested in, using low-cost index funds, and then let the aggregate result of those sectors be your result, absent the unnecessary, and, over time, self-defeating costs.