Index Vs. Actively Managed Funds. There’s a Big Difference
Many studies over the years have consistently shown over time that index funds outperform actively managed mutual funds. According to the S&P Dow Jones Indices SPIVA (S&P Indexes vs. Active management) study, more 86 percent of all actively managed U.S. stock funds have underperformed their index during the last 10 years. Eighty-three percent of actively managed government bond funds underperformed their index as well.
Actively managed funds
Many mutual funds are professionally or “actively managed.” An actively managed fund tries to beat the market by selecting stocks the manager expects to outperform the index. Shareholders in actively managed funds pay an average annual fee of approximately 1.2 percent on the amount of assets they invest in these funds in the hopes that the fund manager’s selections will outperform his or her respective index.
Index funds are mutual funds that are designed to track the performance of a particular index or asset category of stocks and bonds. Unlike actively managed funds, index funds make no attempt to select which investments will be hot. They simply invest in all stocks or bonds within a particular asset class. As a result, index funds can reduce their expenses. Index funds have an average annual expense ratio of 0.5 percent. Vanguard has index funds with an average expense ratio of just 0.1 percent. This means, that on average an index fund can begin each year with a 1.1 percent head start on actively-managed funds. How much of a difference can that make?
The accompanying chart compares the performance of an actively managed mutual fund and an index fund. Each fund has an initial value of $500,000 and earns an annual return of 8 percent over a 10-year period. The actively managed fund has an expense ratio of 1.2 percent and the index fund has an expense ration of 0.1 percent. After 10 years, the actively managed funds fees ($88,283) were more than 10 times higher than the index funds fees ($7,778).
The $80,505 of savings in fees combined with an additional $32,000 from compounding, accounted for the index funds additional $112,016 of savings.
Anyone who has read this column over the last 18 years knows I am big proponent of index funds. At Capital Wealth Management, approximately 75 percent of our clients’ assets are diversified across multiple asset classes of both stock and bond index funds. Actively managed funds would be worth their higher fees and expenses if they delivered superior performance.
However, numerous studies have consistently shown that they do not. Academic research points overwhelmingly to the superiority of indexing versus the average active manager. Index funds have lower costs, are more tax-efficient, more diversified, more transparent and more consistent than actively managed funds.
Martin Krikorian is president of Capital Wealth Management, a registered investment adviser providing “Fee-Only” investment management services located at 9 Billerica Road, Chelmsford. He is the author of the investment books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Better Investor.” Martin can be reached at 978-244-9254, Capital Wealth Management’s website, www.capitalwealthmngt.com , or via email at, firstname.lastname@example.org .