The reputation of passive investing through index funds and their ETF counterparts has been pristine in recent years.
In 2014, only 10% of active stock funds that focus on big U.S. firms beat the S&P 500 stock index. And this kind of under-achievement from actively managed funds isn’t just a one year trend. Burton Malkiel, professor of economics emeritus at Princeton University and author of A Random Walk Down Wall Street (now in its 11th edition after 42 years) has been studying active versus passive investing prior to even his first edition where he recommended passive investing. He had the following to say,
“Every time I update a new edition, typically every four years, I get the same results: A low-cost index outperforms two-thirds or more of active managers over time. And the one-third that outperform are never the same from one period to the next.”
Morningstar, an investment research firm, found that in 2014 U.S. equity funds lost $98.4 billion in outflows, while passive U.S. equity funds received $166.6 billion in inflows from investors. More and more investors are catching on that passive investing is the place to be – and the dollars are following.
Impressive change, however, in that very same report the following numbers REALLY jumped out at me:
- Total active managed fund U.S. assets: $9.753 trillion
- Total passive managed fund U.S. assets: $4.156 trillion
That’s right – over 70% of U.S. assets invested in mutual and exchange traded funds are still in actively managed funds!
This begs the question: whyyyyyyy?
If passive index funds and ETF’s are so great, why doesn’t everyone invest in them?
I think there are four answers to that question – none of which are legit or good for the investor. Let’s start with the most common.
The Desire to Outperform Index Averages
I’m going to give a little personal story here that illustrates the mentality that leads to active managed fund investment. Prior to starting this blog, I was an avid believer in actively managed funds. And what better way to pick those funds than actual performance? So, I combed through fund rankings and found CGMFX – a focused actively managed U.S. mutual fund. Its manager, Ken Heebner, had been absolutely trouncing the S&P500 index over three and five year periods. CGMFX’s performance (in blue) looked like this compared to the S&P500 (in red):
My thought process at the time was,
“Wow, look at that! A 146% return versus the S&P 500’s measly 55% over the previous 3 years. Well, this guy clearly has a legit track record of consistently outperforming the market averages. And a 5-star fund ranking! He must know his stuff and have the winning formula. I want to outperform as well. A 2% expense ratio is nothing when you’re beating the averages by 30% per year!”
So I invested most of the little personal savings I had in CGMFX. Then this happened in 2008 and beyond…
Of course, I sold right near the bottom in 2009, but as you’ll notice, the S&P500 ended up returning over 80% over the 10-year period while CGMFX returned around 30%. CGMFX, with it’s 2% expense ratio (compared to nearly 0% for any S&P500 index fund), now has a 1-star fund ranking.
The reality is that some managers beat the indexes some of the time (and get a huge influx of investments from those hoping to beat the averages), but then they come back down to earth. Close to none beat the averages consistently over long periods of time. Meanwhile, they’ve cashed in on your expense ratio fees.
Everybody thinks they are above average in most things in life – no less with stock/fund picking. I fell into that trap, when in reality, I didn’t know anything about investing at the time. Don’t make the same mistake.
Our 401K’s Suck, with Limited Index Options
Very few individual investors invest outside of a 401K. That’s a problem, when it comes to diversity and ability to choose index funds. A study found that 401K’s have an average of only 25 fund options – with an average of only 3.7 index funds per. As a result, only 23% of 401K assets are invested in index funds.
Ever wonder why your 401K sucks?
It’s disturbingly simple. HR departments like to keep the administrative costs of 401K’s low, so instead of directly paying management fees they let the 401K administrator choose the investment options. The problem with that is that the administrator often will limit fund choices to the funds that are most profitable to them (often their own funds). With these agreements, the costs are shifted from employer to employee – just as they were with the shift from defined benefit pensions to defined contribution 401K’s.
Anecdotally, prior to my current 401K, my previous two 401K’s had less than 20 mutual funds and zero index fund options. Mrs. 20SF’s newest 403B is through Fidelity and 80%+ of the investment options are Fidelity mutual funds.
If your 401K or other employer-sponsored retirement offers little in the way of passive index funds, demand better.
Another reason why investors are still overly smitten with actively managed mutual funds is that they have a lot of marketing/advertising dollars behind them. Investment brokerages make more money through managed funds so they put more advertising dollars and spotlight behind them than they do their index fund offerings (Vanguard being the rare exception).
Many actively managed mutual funds work in advertising fees into their overall management fees. When you charge a 1%+ expense ratio, there is much more room for this than when you charge 0.1% for an index fund.
And the advertising works. How many “our funds beat their averages” ads have you seen or heard? They must work. It’s easy to highlight short-term results with actively managed mutual funds. And even if they did have dollars behind them, it’s much harder to advertise “performed to its index average” for a passive index fund. Bottom line: index funds have no sex appeal or marketing/advertising dollars behind them.
Conflicts of Interest
An advisor or broker who is not under fiduciary standard might earn undisclosed fees that could create a conflict of interest and taint his/her objectivity – with no requirement to disclose those fees and conflicts of interest. The only requirement for advisors/brokers not under the fiduciary standard is that a product be “suitable” for a customer – not necessarily “the most suitable”.
Yes – this is at the center of the White House’s call for an expansion of the fiduciary standard and the financial industry’s strong opposition to it.
Advisors and brokers that are not under the fiduciary standard are incentivized to sell products that generate the most commissions – which are often mutual funds run by his/her firm or high commission funds from other firms. What funds generate the most commissions? Hint: it’s not the index fund with a 0.1% expense ratio.
If you work with an advisor or broker, ask them if they are under the fiduciary standard. If they answer “yes”, have them put it in writing. If they answer “no”, look elsewhere. And you should only work with advisors that charge by set fees. When choosing a financial planner, make sure you limit conflict of interest.
And – start embracing passive funds versus active. Passive investing may seem boring, but that’s partly why it’s spectacular.
- Do you still invest in actively managed funds? Why or why not?
- What percent of your assets are in active and passive managed funds?
Worth noting, just because you see an index in a 401k menu doesn’t mean it’s cheap. Plans can be setup 1000s of different ways with different share classes- even indexes. While it’s not the norm, there can be index options in a plan that have upwards of 1-1.5% expense ratios in a 401k, while they might be 0.1% otherwise. So, always check your expense ratios in a plan as one of the main advantages indexes have is the major fee difference. If that isn’t there, then the waters become muddied.
1.5% expense ratio on an index fund? Good grief. That administrator should be fired. I guess keeping an eye on even index fund expense ratios is good feedback.
For my 401K, I have 50% in Vanguard’s S&P 500 Admiral Shares Fund, and the other 50% in one of Vanguard’s Target Date funds, my rationale being the Target Date fund gets me some diversity without much expense. However, I’ve been thinking of taking my money out of the Target Date fund and dividing it between some additional index funds (international, small cap, etc), but am stalling because I’m not sure its a good move or not. Any advice on how to best diversify among index funds is welcome :)
S&P 500 is heavily U.S. focused (even though a lot of companies do business globally). And it’s also large cap focused. So you’re missing small/mid cap, international, and bonds for more diversity. Target date funds do offer some diversity, but you’ll have to look at the holdings.
I wonder if those numbers might be top heavy, with wealthy investors choosing managed funds with tax minimizing strategies.
Good thought, but the numbers don’t prove out. Municipal bond funds make up only 5% of active fund assets. The rest are taxable. And ETF’s and index funds are well regarded for their capital gains tax efficiencies comparatively.
It would be interesting to know what share of retail/average investor assets are split between active and passive. The total numbers above include institutional assets, which is a huge share of assets and skews heavily toward active management. I’d like to know, for Average Joe investor, how does the active v. passive divide look?
I keep about 80-90% of my investments in index funds, but still believe there is a place for active management particularly with funds tilted toward value, small, and international. And I only use very low fee active funds…Vanguard, T. Rowe, Dodge & Cox. Rather than keeping some “play money” for individual stock picking, as some investors do, I use my play money to invest in active funds. It’s a very low-risk, and low-cost if done right, way to potentially increase returns and have a little fun if you’re interested in the fund world.
I agree that passive funds are superior to active funds, but if active funds’ heavy advertising get people to invest in them v. not investing them at all, those investors are still better off than keeping their money in a savings account. I don’t have any research to back me up here, but I’d be stunned if the majority of active funds, even with their high expense ratios, tax inefficiencies, etc. don’t usually beat inflation.
I think this comes down to maintenance of investments more than anything. Put your money in and not think/worry about it knowing you’re going to match whatever the market yields is one strategy. I don’t consider myself an active trader but I do monitor my return of my retirement assets compared to each of the investments benchmark. Back to back under performing quarters puts the investment on my watch list and after the third, I move my investment to another option. Also, you can’t look simply at charts to arrive at total return as capital gains distributions take place. Basic charts typically do not really take these into account when comparing to benchmarks.
My wife got burned by the charm of the CGM Focus fund too. Key is to not chase returns blindly and truly understand the risk/reward of any investment. Good article GE.
I think the first reason you gave is the primary one why people are still choosing active. Everyone wants to be the “best” and they don’t want to just make average S&P 500 returns (which are still great long term returns). But there’s the whole risk reward thing again, as you are taking a big risk to get that reward, which may not even be that rewarding after fund fees and expenses.
Investing should be about getting great returns with the lowest risk possible, and a well diversified index fund portfolio will do just that.
Although the majority of my money goes into index funds, I still set aside a certain portion for actively managed funds that I specifically choose. I look for funds focused on small/mid-cap companies and special situations because these are the areas where a good manager can easily beat a passive index. Also, I want the fund to have a single manager (no committees) with a reasonably solid track record (i.e. consistency over 5-10 years rather than home runs), and relatively small amount of assets to manage.
As for 401Ks, etc., it depends far more on the employer than the company who keeps the records and provides advice. No surprise that larger employers can bargain a better deal from their employees than small companies. Some 401Ks have lower expense ratios than the cheapest index funds you’ll find at Vanguard/Fidelity/Schwab. If your wife’s Fidelity 403B has Spartan funds, they should be competitive with Vanguard. (For their part, Schwab’s index funds had the lowest expense ratios last time I checked).
The White House’s fiduciary standard proposal actually sounds like a good step in the right direction. I don’t think the larger fund managers have so much to fear from it because they’re already competitive, but I hope it helps improve the choices for small companies that are often stuck offering high-fee funds to their employees.
Jason, I completely agree that small caps are an area where active management can add meaningful alpha. I’m curious, though, about why you are drawn to funds with single managers rather than management teams? I have always preferred team management for consistency, Dodge & Cox is the classic example. The number of funds run by the same single manager for more than 10 years is extremely tiny as is, and star managers will eventually flame out or simply move on. But perhaps you have another way of thinking about it or have had a bad experience with team-managed funds? Would be interested to hear more on your approach.
Good question. My thinking begins with passively managed funds/ETFs being the foundation of a long-term investment portfolio. To go beyond them requires a compelling reason.
Alpha, practically by definition, is found by individual investment managers. I am convinced the skills of excellent managers do not translate well to committees. If you look at any great company or organization, you’re going to find the most important decisions are concentrated among one or two individuals. I don’t think a fund is any different. Plus, with only one or two managers, a successful fund must be focused in some niche of the investing universe outside the reach of passive funds. (I didn’t get into this earlier, but when I see two managers with long tenure, that tells me they operate like a single like-minded manager, and perhaps even more effectively).
Dodge & Cox is an excellent fund, yet its 10-15 year history of returns basically run alongside the S&P 500 (sometimes outperforming, sometimes not). Why invest with them when so many index funds can be just as consistent for practically no cost? (And the answer for many investors: their workplace retirement plan only offers actively managed funds, and Dodge & Cox is among the best in that group).
I had a conversation with a hedge fund manager last night about this.
He said that his fund beat the S&P by 5% last year. However they charge a 2% management fee and keep 20% of the profits.
I ran the numbers to see if it was worth it. Assuming one invests $250,000 (the funds minimum) and the S&P returns 10% whereas the fund returns 15%, I calculated a difference of $400 in profit (in favor of the hedge fund).
To me this simply isn’t worth it because I’d many of the reasons you mention in your article.
Still interesting that so many wealthy people are willing to invest in hedge funds, but it’s their money, not mine!
I’m glad you are writing about this topic, because this issue is allowing thee financial industry to extract billions of dollars from investors’ retirements. Active funds are probably almost as bad of an investment decision as trying to pick your own stocks; however, the solution is not just index funds. There are lots of index funds that have costs that are too high (industry average 1%). I prefer low cost index funds like Vanguard’s SP500 Admiral, which has a .05% management fee each year. That’s practically free, and it gives me nightmares to think of all the people giving up 1% of their money each year for the privilege of underperforming this low cost fund.
>The reality is that some managers beat the indexes some of the time (and get a huge influx of investments from those hoping to beat the averages), but then they come back down to earth. Close to none beat the averages consistently over long periods of time.
Anyone who says they can’t find funds that consistently beat the market is like Cardinal Bellarmine refusing to look through Galelio’s telescope. You focus on one fund, for 3-5 year periods. Misleading.
The following Fidelity funds have matched or bettered the S&P 500, for periods of at least 10 years.
Ticker Symbol – Full Title /Avg Annual Growth / Year of Inception / Annual fee. Asterisk (*) indicates 4 or 5 star Morningstar rating. Info accurate as of late December 2017
FCNTX – Fidelity Contrafund – 12.58% / 1967 / 0.68% *
FMAGX – Fidelity Magellan Fund / 16.05% / 1963 / 0.68%
FMILX – Fidelity New Millenium Fund/ 13.43% /1992 / 0.54%
FOCPX – Fidelity OTC Portfolio / 13.82% / 1984 / 0.84% *
FTRNX – Fidelity Trend Fund / 11.84% / 1958 / 0.74% *
FBGRX – Fidelity Blue Chip Growth Fund / 11.69% / 1987 / 0.70% *
PARWX – Parnasus Endeavor Fund Shares / 12.84% / 2005 / 0.95% *
FLPSX – Fidelity Low Priced Stock Fund / 13.86% / 1989 / 0.68% *
FDVLX – Fidelity Value Fund / 12.27% / 1978 / 0.67%
FLVCX – Leveraged Company Stock Fund / 12.33 % / 2000 / 0.80%
FCPVX – Fidelity Small Cap Value Fund / 11.56% / 2004 / 0.99% *
FISMX – Fidelity Small Cap International Fund / 14.35% / 2002 / 1.34% *
FSRPX – Fidelity Select Retailing Portfolio – 13.78% / 1985 / 0.78% *
FDLSX – Select Leisure Portfolio – 14.07% / 1984 / 0.80% / 0.80% *
FDFAX – Select Consumer Staples Portfolio / 12.69% / 1985 / 0.76%
FSCHX – Fidelity Select Chemicals Portfolio / 14.25% / 1985 / 0.80% *
FSPHX – Fidelity Select Health Care Portfolio /15.78% / 1981 / 0.74% *
FBIOX – Fidelity Select Biotechnology Portfolio / 13.58% / 0.75%
FSPTX – Select Technology Portfolio / 13.21% / 1981 / 0.77%
FSCSX – Fidelity Select Software and IT Services Porfolio / 15.99% / 1985 / 0.76% *
FSRFX – Fidelity Select Transportation Porfolio / 12.99% / 1986 / 0.83% *
FSELX – Fidelity Select Semiconductors Portfolio / 12.46% / 1985 / 0.77% *
FBMPX – Fidelity Select Multimedia Portfolio / 12.42% / 1986 / 0.82%
FSDAX – Fidelity Select Defense and Aerospace Portfolio / 12.16% / 1984 / 0.79% *
And that’s just Fidelity. LEXCX has beaten the market for over 50 years. T Rowe Price has a small cap fund that’s beaten the market since 1956 (OTFCX). Franklin-Templeton has a few funds that have beaten the market since about 1980. Et cetera, et cetera, et cetera.
I don’t invest in anything that doesn’t at least match the returns I can get from the S&P 500. I know people who are enamored of VTSAX, which has low low fees and exposure to the entire market (quote unquote), but also has an annual growth rate of only 6.5%. No thanks. I don’t want funds that under-perform the baseline by that much. Higher growth + higher fees leads to greater wealth than low fees + low returns.
Active funds protect downside risk. Index/ETF do not.