Fund managers are great about touting their achievements and market-beating returns. However, when they can't even keep pace with an index, they suddenly grow silent. Mutual fund investors looking to get the most for their money would be wise to ignore actively managed funds entirely and build a well-diversified portfolio constructed of low-cost index funds.
What are Index Funds?
Index funds are mutual funds that track a specific index or set of guidelines. Rather than trying to beat the index, the fund simply mimics it by purchasing all of the securities in the same proportion as the index it is tracking. Index funds can track a plethora of indices, including Standard & Poor's 500 or the Lehman Aggregate Bond Index, and strategies based on specific criteria, such as dividends or earnings.
Index Fund Benefits
The overwhelming benefit of investing in index funds is the lower costs investors incur compared to investing in actively managed funds, which leads to lagging returns. Because active funds are striving to outperform their benchmarks and competitors, they must employ a team of analysts and managers to choose what they deem to be the best investments. Those costs are passed directly to the investors through higher fees.
Mutual fund managers have discovered a variety of ways to pass fees (profits for them) onto their customers. One such fee is called a load. When an investor purchases a fund with a load, they are typically paying a percentage up front to buy the fund, something index funds don't charge. If an investor decides to invest $10,000 into a fund with a 5% load, the money they actually invest is only $9,500. Right from the start, the investor is hoping the manager can make up that 5% loss. There are also ongoing fees that fund managers charge their investors on an annual basis. These fees typically fall in the range of 1% to 1.5% compared to roughly .03% for index funds.
Furthermore, as active managers battle to earn their keep and beat the index, they actively buy and sell securities. These fees are paid to the funds' brokers and are above and beyond the funds' management fees. This rapid turnover also leads to additional tax liabilities for investors.
Active fund managers have a tremendous amount of ground to make up right from the beginning. Although in the short term a majority of managers will outperform the index, they may not maintain that momentum over longer periods. History shows that a majority of all actively managed funds will under perform their benchmark index. This point is illustrated in detail in a Standard & Poor's report, which contains several different scenarios. It shows that, over two distint five-year periods, actively managed funds in a variety of categories were overwhelmingly outperformed by their benchmarks. The report also demonstrates that benchmarks, which index funds duplicate, typically outperform actively managed funds over one, three, and five year time periods.
Diligent Investing
As always, investors should perform their own due diligence and develop an investing strategy based on their needs. However, in general, investors will find it difficult to find a fund they can rely on to consistently outperform a relevant index. They would be better served selecting a diverse group of index funds, sit back, and relax.
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