The debate ends here! Index Funds vs. Active Funds

Active Funds vs. Passive Funds

The age old debate of whether to invest in an Index (Passive) or an Actively Managed Fund is raging again.  In an article published by Financial Times in October of 2016 calls into question the industry’s reasoning for charging higher fees for their expertise when in fact, the Actively Managed crowd has almost universally lagged the US, Global and emerging markets benchmarks.

According to Financial Times, 99% of actively managed US Equity funds sold in Europe have failed to beat the S&P 500 over the last 10 years.  Only 2% of Global Equity funds have beaten the S&P Global 1200 index since 2006 and almost 97% of Emerging Market Actively Managed Funds have underperformed in that same timeframe. 

The article goes on to say that due to these dismal numbers (my words, not theirs); Passive Funds such as Index Funds and ETF’s that track an Index have grown 4x faster than Actively Managed Funds since 2007.

A second article published in USA Today back in March of 2016 echoed similar sentiments.   A scorecard released by S&P Dow Jones Indices reported that 2 out of 3 Fund Managers “underperformed” the stock benchmark that they are measured against.  To make matters worse, 84% of Large Cap funds posted lower returns than the S&P 500 Index itself over the last 5 years and 82% fell shy of the S&P 500 over the past 10 years.

Fund managers in charge of Mid Cap and Small cap did a little better than their Large Cap brethren, well somewhat better.  Only (wink, wink) 57% of Actively managed Mid-Cap funds trailed their respective benchmark and 72% of Small Cap managers lagged their benchmark.

With such compelling data, why would investors pay 50-100%+ extra in fees to lag the index these Managers are paid to beat?

Well let’s give these Guys and Gals one more shot.  A third article on the touchy subject of Passive vs. Active Management was published a year ago on Forbes.com.  The S&P Dow Jones Indices Research shows that no mutual fund has ever stayed in the top quartile for more than 5 years and only a handful managed to stay in the top half for five consecutive years.

Its not that these people aren’t smart, these are some of the best and brightest mind in Finance, the problem they face is twofold.

One is the problem of too much money to manage.  These funds have so much money that is nearly impossible to have it all invested in quality companies and really invest in the best of the best.  The managers have to put the money to work and this inevitably means buying into companies that they probably wouldn’t otherwise even give a second look.  This is what leads to problem number two.

Over diversification.  They own way too many stocks that even the “good” picks can’t make up for the dismal run of the mill returns most stocks produce.  These managers are basically forced by the rules to water down their potential returns.

I’m not completely anti Active Fund management.  Two of my hero’s were the best ever at actively managing Funds.  Peter Lynch and Jack Dreyfus were two of the best Managers ever.  Their respective funds had some of the best returns in the history of the stock market.  However, with over 8000 funds to choose from, how can you be sure you’ll pick the next Peter Lynch or Jack Dreyfus?  Furthermore, as the numbers have shown, even if you do get lucky picking the great next manager, you’ll only outperform the index for about 5 years (according to the Forbes article) before you need to find your next Peter or Jack.  Who the hell has the time to do that research?

In my 20+ years experience I know this; the general investing public falls into these two categories; Passive and Actively involved.

The Passive investors know that they need to invest to secure their financial future.  These individuals want to make their money work for them with as little work as possible.  There’s nothing wrong with this as long as you implement the right strategy from the beginning.  Set your plan on Autopilot and monitor it a few times a year at most.  Learn more here.

The Actively involved investors follow the same plan as the Passive group when it comes to Autopilot investing but are also actively involved with investing in individual Stocks.  Individual stock investing is not and never should be buy and forget.  If you buy individual stocks you NEED to be active and observant.  I’m not talking about day trading but you better know what you own and when to sell.

If you are a long-term investor weather Active or Passive, find an inexpensive Index Fund or Index ETF and invest every month for as long as possible.  You do not need to find the next Peter Lynch or Jack Dreyfus to build a fortune.  Let time and the market do its work and go enjoy life.

Until next time, Be the smartest Investor in the room.

Welcome to the Nerdery,

Chad