Index funds (still) beat managed funds

In most cases, a portfolio of low-cost index funds, which are cheaper and more taxefficient than their managed cousins, is the way to go.

It’s time to return to a core concept of investing: the difference between a managed and an index fund.

Managed mutual funds rely on research, market forecasting, and a tenured portfolio manager and/or management team to attempt to outperform their relevant benchmarks. Conversely, index funds track the performance of a particular market benchmark, like the S&P 500, by purchasing each of the securities that comprises the index.

Of course, research, expertise and the potential to generate better returns than the index comes at a price: According to the Investment Company Institute (ICI), average fees on actively managed equity funds were 89 basis points (0.89 percent) in 2013, compared with 12 basis points (0.12 percent) for index equity funds.

Now, if the pros that oversee managed mutual funds can consistently beat the index against which they are compared by more than 77 basis points every year, then you might opt to pay up. Unfortunately, very few managed funds outperform their relevant indexes.

S&P Dow Jones Indices has found that not many managed funds are able consistently to reach the top quartile of performance over five successive years. In fact, fewer than 1 percent of funds stay above the fray for five years.

At the end of 2014, it reported, “86.44 percent of large-cap fund managers underperformed the benchmark over a one-year period. Over five- and 10-year periods, respectively, 88.65 percent and 82.07 percent of large-cap managers failed to deliver incremental returns over the benchmark.” Most mid-cap, smallcap and international managed funds also lagged their benchmarks.

The easiest explanation for the underperformance is the fee differential. After all, it’s tough to beat the index when you start the year in the hole by nearly 0.8 percent. But Jeff Somer of the New York Times asked S&P Dow Jones to scrub the data to eliminate the effects of fees. “Even without expenses, they found, nearly all actively managed domestic stock funds trailed the benchmarks over three, five and 10 years. Large-cap funds were the single exception, and only over 10 years.”

The myth of being able to beat the market is even more widespread in the hedge fund industry, which charges about 2 percent annual management fees as well as 20 percent of any upside profits. Last year, hedge fund annual returns averaged just 2.5 percent for the year, according to eVestment, a data tracker, almost 9 percentage points less than the S&P 500.

Optimistic investors want to believe that there’s a wizard behind the curtain who can help them “beat the market,” but study after study finds that the simplest and most lucrative approach to investing may be the best. In most cases, creating a portfolio of low-cost index funds, which are cheaper and more tax-efficient than their managed cousins, is the way to go.

Of course, using index funds does not guarantee investment success. Even when investors use cheaper funds, they still tend to buy when markets are soaring and sell when they collapse. Be sure to build a diversified portfolio that factors in your risk tolerance and time horizon. Then populate the portfolio with index funds, and rebalance quarterly. And pay no attention to that man behind the curtain!