Why Most of Your Assets Should be in Index Funds

Daniel Penzing
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Most Fund Managers Don’t Beat the S&P 500

Why not be an Outlier?

Most money managers don’t beat the market. They’re like road kill on the highway of investing …at least that’s what the data suggests. From 2000 to 2009, fund managers of large-cap growth funds (who are supposed to bring in the big returns) underperformed the S&P 500 by a massive 10.6% per year. Large cap value managers underperformed by an even worse 10.2%, and mid cap growth managers underperformed by 8.9%.

Not only that, but for the last 15 years, 89% of large cap growth fund managers and 92% of large cap value fund managers have failed to beat their benchmarks, according to Lipper.

It gets worse for smaller-cap managers. If you were unfortunate enough to invest in a small-cap growth manager, you would have gotten an abysmal -8.5% per year over the last 15 years. Investing in a small cap value manager would have brought an even worse -9.2% per year.

Interestingly, the academic research also shows that most managers fail to beat their benchmarks.

Actively Managed Funds and Individual Stocks Require More Action from You

Many financially savvy people will advise you to put most of your assets in index funds. This method might seem like common sense, but there are several reasons why you’ll want to listen to their advice.

Index funds simply track the underlying index. For example, if you buy a fund that tracks the S&P 500, it will only buy the stocks in the S&P 500 index. No matter what happens, it cannot invest in any other stocks (although it may try to capitalize on market-timing opportunities).

By contrast, actively managed funds can invest in other companies that aren’t included in the index. For example, they might buy up shares of Apple when they’re on sale or short stocks when they’re overpriced. This gives these funds the opportunity to achieve better returns on average.

However, this doesn’t mean that you should buy an actively managed fund. With the proliferation of index funds, there are plenty of options that can mimic the market. These passively managed index funds will offer the same returns (on average) as most actively managed funds, but they’ll typically have lower management fees.

“Small” Investment Fees Diminish your Returns in a Big Way

The total fees an investor will pay to obtain exposure to the listed market will be composed of several different categories of fees. The most obvious will be the expense ratio of the fund. If the fund is not an index fund, the manager may charge additional fees called 12b-1 fees (also called distribution or marketing fees). Although these are often quite small, they can still add up over time.

There are many other types of advisory and implementation fees that could apply to the specific investments in the portfolio. As investors move away from index fund to other more individually tailored products, the fees will start to add up.

Fees are alluded to on fund websites but are rarely quantified. In some cases, they are simply swept under the rug. This is especially true when comparing similar products that are trying to hide their weaknesses.

Obviously, the fee an investor pays must be considered when evaluating returns. In fact, if an investor consistently over a long period of time underperforms the appropriate index, he or she should ask for their money back!

Winning Strategy: Keep Most of Your Portfolio in Index Funds