Some people believe that they can beat the market over the long term. Unfortunately, these people are wrong. Active investing or passive index funds is a debate many people ask themselves? However, for most people, investing in passive index funds will likely result in better performance.
Active investors think they can beat the markets. They may look up company reports, scour for little-known information, and study trends and ratios for hours at a time. And after many moves and trades, these active investors may believe that they have actually beaten the market. But it is usually because they haven't actually experienced being invested during a bear market.
Sometimes savvy investors actually do beat the general market. For example, their returns may be far better than the earnings of the Dow or the S&P 500. But, are their brilliant trades repeatable? Is excellent performance even sustainable from one year to the next?
After over 25 years of investing actively and passively, let's do a little deep dive analysis.
Active Investing Or Passive Index Investing
A study performed by the S&P Dow Jones Indices explored the question, “Does past performance matter?” When researching for the study, the analysts selected domestic stock funds that performed within the top 25% of other like-traded funds in 2016. Then, these analysts observed how many of these managed funds remained in the top 25% over the course of the next four years.
Out of the original 2,862 funds that were selected for the study, only 2 performed in the top 25% of the domestic stock funds in each of the five years. Even among highly skilled fund managers, past performance is not easily repeatable when it comes to the intricacies of the ever-changing stock market. Take a look at the below chart that the NY Times put together based on the study.
In the same light, questions often arise regarding actively managed funds vs. a benchmark index (the common reference of index returns is the S&P 500). Which funds, on average, provide the highest returns: the Index or an actively managed stock fund?
The basic premise is that the actively managed funds would provide a higher return because there is an incredibly intelligent fund manager at the helm of each transaction. When the market takes an unexpected turn, the fund manager can make an immediate change. If successful, the manager can save investors from losses that they would have otherwise experienced had they been investing on their own.
Theoretically, professional fund managers should also be able to spot trends in the market and trade for higher gains than the Average Joe, who isn’t able to devote the same amount of time to such research.
Few Active Investing Fund Managers Outperform
Research has shows that average actively managed funds did outperform passive indices, but only by 0.12%. And this is prior to factoring in the different fees associated with the active trades made by the fund managers.
As seen in the graph above, approximately 46% of active funds in this study earned a return between 0% and 5% after all of the fees were considered. Another 41% of active funds earned a return between 5% and 10%. That by itself doesn’t sound like a bad return at all. But when compared to the earnings of the passive index investments, they pale in comparison to the 68% majority of index funds that earned between 5% and 10% each year.
If the general stock market earns 8% over the course of a year, then the average actively traded mutual fund would earn 8.12% (slightly above the average) based on the study referenced above. However, with many funds charging fees between 1% and 3%, the average returns of these funds land below that of the general market, therefore creating the negative-sum game.
Terrible Performance By Actively Run Equity Mutual Funds
Look below at how terrible equity mutual funds have performed versus their respective benchmarks over the past 10 years. The vast majority of actively run mutual funds underperform.
What Types Of Fees Are Funds Charging?
When investing in actively traded mutual funds, there are many fees to be aware. These fees ultimately minimize your returns. When debating between active investing or passive index funds, the active investing fees are really what do active fund managers in.
1) Expense Ratios – These are often the most visible fees within your investments. Expressed as a ratio (such as 0.90), this number represents a percentage fee, which covers the costs associated with running the mutual fund. These fees cover salaries of the fund’s employees. The fees also cover other costs of operation such as computers, the building lease, and office supplies.
2) 12B1 Fees – Not every mutual fund charges 12B1 fees, but many do, which can cost another 0.25% of your investment. These fees cover marketing expenses such as online ads, magazine ads, and television commercials.
3) Trading Costs – As the managers make trades on your behalf, costs are naturally incurred (just as you would incur a cost for making a trade yourself). These often account for another 0.2% that is charged to your account.
4) Sales Commissions – If you choose to have a broker invest money on your behalf, then you’ll likely be charged a fee for their services as well. Also, don’t forget that your broker may be monetarily incentivized to select certain funds over others. They may be tempted to select funds that pay them more, rather than funds that perform the best. If this happens, not only are you paying a fee for their services, but your broker might also be costing you money by choosing an underperforming fund.
Earn Market Returns and Minimize Fees
A great option is to let a robo-advisor like Personal Capital manage your money. They charge a low cost of 0.89% or less with no minimum balance. Their digital investing service will invest your money in Vanguard ETFs in a customized allocation based on your risk tolerance. Therefore, you are earning closer to index market returns. Below is an example of a model portfolio for someone with a 2/10 risk tolerance.
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