March 21, 2012

Index Funds Win Big

Heres a piece from Moneyland that says index funds win by a landslide. The summary:

Index mutual funds trounced actively managed mutual funds last year by the widest margin in 15 years, once again raising the confounding question: Why do so many individuals gravitate to actively managed funds when they are a proven loser?

Among large-cap fund managers, 79% trailed the return of the S&P 500, says fund tracker Morningstar.

Of course, this is just for one year. A look at another year will show index funds not doing as well. That said, index funds do better on average in most years:

Sadly, these results aren’t all that unusual. More than half of active managers underperform their benchmark year after year. According to the latest S&P Index Versus Active (SPIVA) scorecard: “Over the past three years, which can be characterized by volatile market conditions, 64% of actively managed large-cap funds were outperformed by the S&P 500; 75% of mid-cap funds were outperformed by the S&P MidCap 400; and 63% of the small-cap funds were outperformed by the S&P SmallCap 600.”

The piece then gets to what makes index funds such attractive investments:

The odds of winning are greatly enhanced through lower costs. That’s where index funds enjoy an advantage. According to Money magazine, annual expenses of actively managed funds average 1.3% of assets while index fund expenses average just .69% of assets. Meanwhile, some of the best-known S&P 500 index funds charge less than .2%. In that case, a large-cap manager must beat the market by more than a full percentage point to merely equal the return of the index.

This is a HUGE difference. Lets look at this info a bit closer:

• Annual expenses of actively managed funds average 1.3% of assets. Yikes! As an index fund investor, 1.3% seems like a GIGANTIC number.

Here are the main three index funds I use and their annual expense ratios:

• Vanguard Total Stock Market Index Admiral (VTSAX) — 0.07% expense ratio

As you can see, all have very, very low expenses. And over a 40-year investment horizon (like for retirement), even fractions of a percentage can add up.

The one thing the article gets wrong is the following:

One explanation for the continuing reliance on active management is the lure of being better than average, which by definition is the fate of all indexers.

This is kind of correct and kind of not. If they are referring to the total (or gross) return, then they are correct. But if they are talking about the net (after expenses) return, they are not (FYI, I explained the difference in The Beauty of Index Funds .) Thats just the point — and thats why we see numbers like we do at the top where, post expenses, index funds beat the vast majority of actively managed funds.

Of course there are those that CAN beat the averages on a regular basis. But just because they can doesnt mean most people can. If you dont believe me, check out the details behind why I invest like I do .