It’s been one of the biggest debate topics within the investment industry—active management versus index funds—and the winner so far has been indexing. In chapter three of his book, “Index Investing for Dummies,” Russell Wild cited evidence from 2007 to back up his claim that indexing is more profitable in the long term (his book was published in 2009).
The outperformance of index funds has continued, according to the SPIVA U.S. Scorecard:
“For the ninth consecutive year, the majority (64.49%) of large-cap funds underperformed the S&P 500. The figures highlight that heightened market volatility does not necessarily result in better relative performance for active investing.”
The same held for small-cap equity fund managers. And, turning to the longer term, the trend is even more pronounced:
“Over the long-term investment horizon, such as 10 or 15 years, 80% or more of active managers across all categories underperformed their respective benchmarks.”
Note, a “benchmark” is the equivalent of an index fund.
With the indexing advantage still holding, we can turn to the reasons why that advantage exists. Wild offered nine reasons.
Minimized costs
The first and best-known advantage is in fund management fees. Managers of index funds do not have to pay for research, they simply add and remove securities according to the rigid rules of the index. In the short term, the difference of a point or half point may not make a material difference, but over the longer term, say three years or more, compounding kicks in and provides an inherent advantage to the indexes.
There are other areas where index funds have lower costs, including trading costs and the spread. The latter term refers to the difference between the prices quoted for the bid and the ask. The difference is pocketed by a broker and the larger the trade, the costlier the transaction. An active manager who makes many trades a year consequently develops an inherent disadvantage.
Predictability through diversification
An index fund, unless it is uniquely specialized, is likely to have a much wider collection of securities than an actively managed fund (again, because of research and trading costs). Generally, the larger the number of different securities, the lower the volatility—and the fewer the opportunities to outperform the market. If an individual company goes bankrupt, the index fund will be less affected.
Avoiding style drift
Active fund managers are often tempted to edge out of their prescribed lanes; for example, the manager of a large-cap fund may see attractive opportunities among mid-cap stocks and start buying mid-cap rather than large-cap companies.
Wild offered this dramatic example: “When the Internet bubble burst in 2000, several funds in the high-flying mutual fund company Janus were simultaneously trounced. It turned out that despite having different names and descriptions, they were holding not only similar stocks but, in many cases, the very same stocks.”
He added it is easier to buy “tight and distinct” baskets by using index funds. Gain even more diversity by investing in several funds, say large-cap and small-cap along with some international index funds.
Taxes
Index funds are generally more tax efficient because they do very little trading, which minimizes capital gains taxes. On the other hand, if you invest in an actively managed fund with a high annual turnover rate, you should expect shocking tax bills sooner or later (is the fund held within or outside a registered vehicle?).
You might even be faced with a big tax bill even though your actively managed fund lost money. The author noted, “A lot of mutual fund investors were stung badly at the onset of the bear market of 2000–2002. Not only did their investments sink, but to add insult to injury, they had to pay capital gains tax on profits made by the fund before they even bought into it!”
Cash drag
How much cash does your fund or exchange-traded fuld hold? Chances are, it will be more if you invest in an actively managed fund. It’s good to have cash on hand in case unexpected opportunities pop up, but there is an opportunity cost. Wild cited 2007 figures from Morningstar showing index funds “hoarding” 5.4% of their assets in cash, while actively managed funds hoarded 7.6%.
That’s a difference of 2.2%, money that is not invested and not bringing in capital gains or interest income. Again, a relatively small difference, but one that will make a difference over time because of compounding. Of course, a heavy weighting in cash is a good thing if the market makes a major correction; fewer shares are exposed to declines and the manager has cash to buy newly discounted stocks.
More transparency
Unless you carefully read a prospectus, you will not learn there are other costs quietly eroding your capital. For example: “Want to avoid unpleasant surprises (in addition to unexpected year-end taxes)? Then you want index funds. With index funds, you won't find the notorious 12-B fees that enrich the industry and allow mutual fund companies to charge you, the shareholder, for their marketing and advertising.”
Nor will you have active managers making quick trades in December, hoping to make the annual returns look better before their performance reviews. You will also avoid paying a sales fee to a salesperson; front- and back-load fees are a notorious drag on mutual fund returns.
Not trying to beat the market
Yes, index funds do have the edge, but there are certainly some managers who are able to beat the market. Shouldn’t we invest our money with them? That might be a good theoretical strategy, but in practice it is much harder. Conditions in the markets change continually, and managers who are hot this year may not be hot next year. Last year’s hero becomes this year’s dog.
Who’s on the other side of the trade?
Wild argued there’s no doubt most active managers are smart people: “These are, by and large, people who know their stuff. These are no financial fools.” So you would think they would have an advantage when buying and selling stocks or other securities. Every deal, however, involves a buyer and a seller, so the active manager on the other side of a trade is likely to be just as smart and informed. Active management professionals cancel out each other’s advantages.
The rigging of financial markets
While the market is mostly fair and efficient, there are exceptions:
- Some CEOs donate gifts of company stock to their own family foundations and receive tax deductions. Research shows many such donations are made just before the stock craters.
- Research also shows that U.S. senators seem to be exceptional market timers. They were able to outperform the market by 12 points a year; what’s more, most of the stocks they bought jumped in value the following year, 29% on average, and soon returned to normal after the senators sold them.
No single one of the nine reasons listed above gives index funds a major advantage over actively managed funds; it’s a point here and a point there, mostly. But combined, they add up to a serious structural advantage for index funds. When considered over the long term, the compounding of those gains makes the advantage of index funds even more stark.
Read more here:
- Indexing for Dummies: The Evolution of Indexes
- Indexing for Dummies: The 'Virtues' of Investing With Index Funds
- Â The Dhando Investor: Indexing the Pabrai-Greenblatt Way
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