It isn't like this would be a fair fight. But get two investors who believe in one or the other in the same room, and the index fund investor would declare their style the winner, based on low cost alone. While fees play an important role in the long-term objectives of any investor, particularly those using mutual funds for retirement, the idea of long-term has seen its day come and go. As Tom Lydon of ETFTrends suggested recently: "The notion of buy-and-hold investing shows signs of falling out of favor. Ten years ago, 80% of advisors’ portfolios were buy-and-hold. Today, that’s 30%."
Which leaves the actively managed mutual fund investor, often described as a resident of Lake Wobegon (where everyone is above average) as the beneficiary of this shift ininvestment style. The question that every index fund investor will ask every opportunity they get: how do you pick an actively managed mutual fund if so many underperform?
And it is a good question. But the problem is, how do you make that call if you are essentially comparing these sorts of funds to those that buy across a broad market? An index fund, for the sake of argument we'll use the S&P500 index as an example, buys the top 500 companies. These companies are in the top 500 due to market capitalization. But index funds don't buy all 500 equally, weighting their funds based on numerous criteria.
Among those are as I mentioned, market cap. To be eligible for this index, a company must have $5 billion of market worth (issued stock) with 50% of that stock available for the public to buy. They must be based in the US - it doesn't matter where they do business as long as the headquarters are on US soil, follow GAAP reporting practices and offer sector representation.
The weighting of an index like this, which many investors assume is done much more evenly, actually gives the top ten companies based on market cap, over 20% of the index, leaving the 490 remaining companies to fill out the rest of the index. How would this sort of style compare to a actively managed mutual fund that owns less than one hundred stocks in their fund? Talk to an indexer or as they often refer to their group as Bogleheads, after the man who brought the index fund into existence (there were attempts made earlier than Mr. Bogle's but the ability to do it correctly was dependent on the advent of the computer) and they would quip, there is no comparison.
Yet, this is the very comparison they make, time and again. Their argument does hold some merit. Index funds have lower fees because they trade only when the index changes. (This is an irony lost on many indexers as the these funds must divest any interest they might have in a stock taken from the index and purchase any security the index has added - a sort of counterintuitive move of selling losers and buying winners.) Many still charge 12b-1 fees even if they are in company sponsored plans and act as the default investment. Over five years, performance of the S&P500 index has been north of 15% and that was due to the large amount of value given those top stocks in the index and the dividends paid by many of these large businesses.
Actively managed funds do have more to contend with in terms of trading (more frequently but the best funds do so prudently without changing their whole portfolio in a given year) research (they aren't given a group of stocks to buy as the index publishers do) and their are management fees (the cost of hiring a professional to wade into the marketplace for you). Yes these do impact the overall returns of a fund and as investors focus more on these items, they have dropped significantly in recent years.
So what do you get with an actively managed fund that isn't there for indexers. Obviously, a bit more nimbleness, less buy-and-hold and if your fund manager is good, acceptable returns. Most investors do still look to the performance - and too often in the short-term, as in a year or even a quarter just past - as the tool most likely in their portfolio picks. Doing this at the exclusion of tenure - how long the manager has been at the helm - the fees - they should be low, under 1% with a portfolio turnover in any given year of less than 60% - and should be able to best their peers in both categories, if not the index they are often compared to, over five years or longer.
Indexed funds have pluses that seem outsized compared to actively managed funds. But too often, a one size fits all approach to investing is not suited for everyone and this is where actively managed funds fill the void left by that sort of approach.
Which leaves the actively managed mutual fund investor, often described as a resident of Lake Wobegon (where everyone is above average) as the beneficiary of this shift ininvestment style. The question that every index fund investor will ask every opportunity they get: how do you pick an actively managed mutual fund if so many underperform?
And it is a good question. But the problem is, how do you make that call if you are essentially comparing these sorts of funds to those that buy across a broad market? An index fund, for the sake of argument we'll use the S&P500 index as an example, buys the top 500 companies. These companies are in the top 500 due to market capitalization. But index funds don't buy all 500 equally, weighting their funds based on numerous criteria.
Among those are as I mentioned, market cap. To be eligible for this index, a company must have $5 billion of market worth (issued stock) with 50% of that stock available for the public to buy. They must be based in the US - it doesn't matter where they do business as long as the headquarters are on US soil, follow GAAP reporting practices and offer sector representation.
The weighting of an index like this, which many investors assume is done much more evenly, actually gives the top ten companies based on market cap, over 20% of the index, leaving the 490 remaining companies to fill out the rest of the index. How would this sort of style compare to a actively managed mutual fund that owns less than one hundred stocks in their fund? Talk to an indexer or as they often refer to their group as Bogleheads, after the man who brought the index fund into existence (there were attempts made earlier than Mr. Bogle's but the ability to do it correctly was dependent on the advent of the computer) and they would quip, there is no comparison.
Yet, this is the very comparison they make, time and again. Their argument does hold some merit. Index funds have lower fees because they trade only when the index changes. (This is an irony lost on many indexers as the these funds must divest any interest they might have in a stock taken from the index and purchase any security the index has added - a sort of counterintuitive move of selling losers and buying winners.) Many still charge 12b-1 fees even if they are in company sponsored plans and act as the default investment. Over five years, performance of the S&P500 index has been north of 15% and that was due to the large amount of value given those top stocks in the index and the dividends paid by many of these large businesses.
Actively managed funds do have more to contend with in terms of trading (more frequently but the best funds do so prudently without changing their whole portfolio in a given year) research (they aren't given a group of stocks to buy as the index publishers do) and their are management fees (the cost of hiring a professional to wade into the marketplace for you). Yes these do impact the overall returns of a fund and as investors focus more on these items, they have dropped significantly in recent years.
So what do you get with an actively managed fund that isn't there for indexers. Obviously, a bit more nimbleness, less buy-and-hold and if your fund manager is good, acceptable returns. Most investors do still look to the performance - and too often in the short-term, as in a year or even a quarter just past - as the tool most likely in their portfolio picks. Doing this at the exclusion of tenure - how long the manager has been at the helm - the fees - they should be low, under 1% with a portfolio turnover in any given year of less than 60% - and should be able to best their peers in both categories, if not the index they are often compared to, over five years or longer.
Indexed funds have pluses that seem outsized compared to actively managed funds. But too often, a one size fits all approach to investing is not suited for everyone and this is where actively managed funds fill the void left by that sort of approach.
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