Following is a second
excerpt from Chapter 6 of the BetterInvesting Mutual Fund Handbook, written by Amy Buttell and recently revised by Danielle Schultz:
Portfolio Managers vs. Indexes
A number of studies reveal that index funds regularly outperform the vast majority of actively managed funds. Although managers often can better the indexes in the short term, studies from S&P and elsewhere indicate that the vast majority of portfolio managers don’t outperform market indexes over the long term.
Experts attribute the performance gap to fund costs, frequent buying and selling, and a short-term focus. Handicapped by high expenses and high turnover, most portfolio managers can’t close the gap with their low-cost, low-turnover, passively managed cousins — index funds.
A few years or quarters of superior performance from an actively managed fund can skew results for years to come, making the fund’s long-term performance seem stronger than it actually is. Many portfolio managers trade frequently. This strategy not only increases brokerage costs, but also raises investors’ tax liabilities.
The high costs of actively managed funds drags their performance down in relation to low-cost index funds. An example of these higher fees is seen in the average expense ratio charged by large core/blend mutual funds, which was 1.17% as of mid-2012, according to Lipper.
Contrast this with the expense ratio of a low-cost index fund. An example of an index fund with rock-bottom costs is the Vanguard 500 Index Fund, itself a large blend fund. This index fund, designed to replicate the performance of the S&P 500, has an expense ratio of 0.17 percent. Since the category average includes low-cost index funds, the average for actively managed funds is likely higher than the 1.17%.
The difference of 1 percentage point translates into $100 of a $10,000 investment that an investor would pay each year of fund ownership. Own $10,000 in shares of a fund with an expense ratio on par with the large-blend category average for five years, and you’ll pay $585 in expenses.
If you owned a similar amount of shares in the Vanguard 500 Index Fund, you’d pay $85 in expenses. The difference in costs is $500, money that you could otherwise invest in fund shares. If your fund shares increased in value during that five-year period — as you would expect they would — your expenses would rise accordingly. If an actively managed fund is not only more expensive than an index fund, but also delivers worse performance, why invest in it? The tools showcased in this book show you how to find funds that meet your investing criteria, while examining costs, composition, and track record.
Fund managers face increased pressure from shareholders and the media to perform as well as a comparable index. This pressure leads managers to purchase many of the same companies that are in the index so that their fund’s performance won’t stray too far from the indexes. So closely do some portfolio managers adhere to index performance measures that their funds become closet index funds. Closet index funds are described as actively managed funds with a portfolio and sector weighting very similar to a particular market index.
This begs the question of why you should pay a portfolio manager to select stocks when you could buy an index fund in the first place. Before you buy shares in an actively managed fund, make sure that manager’s approach offers a credible alternative to an index fund. Fund managers with low turnover, high tax efficiency, and low expenses generally have a better chance of outperforming their peers and a comparable index fund.
When we look at bond funds or alternatives, the considerations of passive vs. active management become slightly different. Since bonds and some alternative investments don’t have the same types of exchanges as the stock exchanges, managers are faced with replicating an index by purchasing (for example) similar bonds with corresponding credit ratings, duration, and yields, rather than a set of identical bonds.
With alternative investments (REITs, commodities, etc.), it can be even harder to match an index. Thus, for some “index” bond or alternative funds, there’s still some component of manager judgment involved. If you’re selecting a bond index fund, it’s very important to monitor how closely the fund matches its benchmark.
Even for ETFs, it’s important to check how closely their trading price matches their NAV (net asset value). It’s possible for some ETFs to vary more than their equivalent mutual funds.
About the ‘Mutual Fund Handbook’
The Mutual Fund Handbook, originally written by Amy Buttell, is $15 for BetterInvesting members ($20 for nonmembers) via the BetterInvesting online store. To get your copy, click here. Or download a free sample chapter of the Mutual Fund Handbook and also try out BetterInvesting’s free mutual fund resources.
About Danielle Schultz
Learn more about Danielle Schultz and read her blog.
About BetterInvesting
BetterInvesting is a national nonprofit organization that has been empowering individual investors since 1951. Founded in Detroit, the association (formerly known as National Association of Investors Corporation) was born out of the conviction that anyone can become a successful long-term investor by following commonsense investing practices. BetterInvesting has helped more than 5 million people become better, more informed investors by providing webinars, in-person events, easy-to-use online tools for analyzing stocks and mutual funds, a monthly magazine and a community of volunteers and like-minded investors. For more information about BetterInvesting, visit its website at http://www.betterinvesting.org/investing/landing/openhouse/blog/index.html or call toll free (877) 275-6242.
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