Index mutual funds trounced actively managed mutual funds last year by the widest margin in 15 years, once again raising the confounding question: Why do so many individuals gravitate to actively managed funds when they are a proven loser?
Among large-cap fund managers, 79% trailed the return of the S&P 500, says fund tracker Morningstar. That is a stunning display of futility—and sadly, these results aren’t all that unusual. More than half of active managers underperform their benchmark year after year. According to the latest S&P Index Versus Active (SPIVA) scorecard:
“Over the past three years, which can be characterized by volatile market conditions, 64% of actively managed large-cap funds were outperformed by the S&P 500; 75% of mid-cap funds were outperformed by the S&P MidCap 400; and 63% of the small-cap funds were outperformed by the S&P SmallCap 600.”
It’s more of the same with foreign stock funds: 57% of global funds, 65% of international funds and 81% of emerging markets funds trailed their benchmarks. What accounts for such steady index outperformance? In large part, it comes down to fees.
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Investing is a zero-sum game. For every stock trade, there is a buy and a sell, representing a winner and a loser. For every investor that outperforms the market, another investor has to underperform. So in aggregate, investors are unable to beat the market because they are the market—half win, half lose. But the odds of winning are greatly enhanced through lower costs.
That’s where index funds enjoy an advantage. According to Money magazine, annual expenses of actively managed funds average 1.3% of assets while index fund expenses average just .69% of assets. Meanwhile, some of the best-known S&P 500 index funds charge less than .2%. In that case, a large-cap manager must beat the market by more than a full percentage point to merely equal the return of the index.
This advantage has not gone unnoticed. Actively managed U.S. stock funds have been losing assets to index funds for a decade. But index funds still account for just a third of all money in stock funds. Some experts worry that the flow to index funds, which hold $1.2 trillion of assets, has reached critical mass and threatens to destabilize the market because so many people are investing in the same manner.
Still, with such steady index dominance, you wonder why almost everyone doesn’t invest this way. Index funds exist in virtually every corner of the global market. Meanwhile, about a third of active managers are “closet indexers” anyway. They mimic their benchmark in an effort to not underperform. Investors in these funds are overpaying, since they could be getting the same results in an index fund for a fraction of the price.
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One explanation for the continuing reliance on active management is the lure of being better than average, which by definition is the fate of all indexers. And there are some tricky categories where active managers have an edge, like international small-cap funds and emerging market bond funds.
But for the most part indexing is the smarter way to go. If you must invest with an active manager, stick to those with the lowest fees. If you index, be sure to diversify beyond the highly popular S&P 500. Make sure you have some small-cap and mid-cap index funds as well as some total market index funds pegged to the Wilshire 5000 and foreign index funds pegged to MSCI global equity indices.
