One of the most popular “sports” in the investing world is trying to beat the market. Investors and fund managers measure their performance largely by how well they perform compared to popular indices, such as the S&P 500 index. But given that professional investment managers typically don’t beat the market – in fact, they are usually behind – most of your assets should be in index funds.
You can look long and hard for fund managers who can beat the indices, but the odds are against you finding success.
Most Fund Managers Don’t Beat the S&P 500
According to the S&P Indices Versus Active, or SPIVA, 60 to 80% of actively managed mutual funds and ETF’s underperformed market indices in various categories for year end 2012. What’s more, the rate of under-performance increases the longer the comparison is made.
An actively managed fund might outperform the market for a year or two, but the evidence weighs heavily against them over periods of five years or more. Many investors will go with actively managed funds based simply on the fact that they outperform the market for a single year. After all, those will be the funds that the financial media will hold up as the stars in their year-end fund rankings.
Actively Managed Funds and Individual Stocks Require More Action from You
Not only do most actively managed funds under-perform the market, but they generally require greater time and attention on your part. If you are investing in index funds, you know the returns will match market performance. But if you are investing heavily in actively managed funds, you will constantly have to monitor those funds to see where you stand.
There can be an even bigger dilemma than it seems at first glance. If you are in a particular managed fund and outperforming the market, you may become complacent, thinking that it will always be this way. But then you can get burned in a big way when that situation reverses.
On the flipside, if you see your fund constantly trailing the market, you might sell at a particularly bad time. Underperformance can lead to panic selling.
Either way, you always have to keep an eye on your fund investments, in much the same way that you would do if you held individual stocks. That largely defeats the purpose of having funds at all.
And speaking of individual stocks, they are at the opposite end of the investment spectrum. If index funds represent passive investing in equities, managing a portfolio of individual stocks is something like a part-time babysitting job – only the stakes are much higher.
“Small” Investment Fees Diminish your Returns in a Big Way
Another major issue in the active-vs.-index funds debate are investment fees. Since index funds track entire markets, their portfolio composition changes only when there are changes made to the index. Since that is fairly infrequent, index funds incur very little in the way of investment fees.
Actively managed funds on the other hand, can adjust portfolio holdings far more frequently and as they do they incur higher investment fees. How high these fees will be will depend upon turnover ratio within the fund. But on those that are on the higher end of the scale – where portfolio turnover exceeds 100% per year – investment fees can be quite high.
If annual average investment fees on an actively managed fund is 1% higher than they are for an index fund, your return on that fund will be lower by 1% each year.
Considering the stock market averages roughly 8% per year over the very long-term, $100,000 invested in an index fund, returning 8%, will produce a portfolio size of $466,000 in 20 years.
Assuming that an actively managed fund will get the same 8% return – but remembering that most don’t – then subtracting out 1% from their return for higher investment fees, your average annual return will be 7%. This will produce a portfolio size of $387,000 in 20 years.
That “small difference” in investment fees becomes big money over long periods of time. In this case, it will cost you $79,000 over 20 years.
It goes without saying that if you manage your own stock portfolio, your investment expenses will be even higher than they will be for actively managed funds. That will make the negative effect on your portfolio even hiher over the decades.
Winning Strategy: Keep Most of Your Portfolio in Index Funds
If you still want to try your hand at going the active management route – either with funds or by managing your own portfolio – an excellent strategy would be to put the majority of your portfolio into index funds, and actively manage the rest.
For example, you might decide to put 80% of your portfolio into index funds, and the remaining 20% into either managed funds or your own stock picks. If you do this, 80% of your money would be passively invested in stocks providing returns that are consistent with the general market. The other 20% would be your attempt to beat the market.
And if your selections turn out be wrong, the hit you will take will only apply to a relatively small slice of your portfolio. If you get it right, you’ll have extra returns – over and above your index funds.
Do you go with index funds, or do you try to be active instead?