Investment Smackdown: Index Funds Versus Actively Managed Funds

I think most of my regular readers will know how this post is going to turn out. ;-)

In a piece called The Joy of Index Funds, Money magazine's Walter Updegrave gives his thoughts on index funds versus actively managed funds in response to a reader's question. I've selected some of his comments that summarize the article. the highlights:

Many [index funds] charge 0.2 percent a year or so, and some have expenses that are even lower, sometimes as low as 0.07 percent. That's a pittance compared with the 1 percent to 1.5 percent or more than most actively managed funds collect from investors.  There's no guarantee, of course, that a particular fund will outperform just because it has low fees. But whenever I've compared the performance of high-fee funds vs. that of low-fee funds over long periods, I've found that as a group the funds with lower charges typically do generate higher returns.

Yes, we know that costs matter if you want to maximize investment returns and it's hard to beat index funds on cost. But there's more to celebrate about index funds:

Like certainty. Index funds slavishly follow an index or benchmark, so you always know what you're getting. You don't have to worry about your large-company fund manager poaching in small caps to juice his returns, or a value manager picking up a few growth stocks to boost performance when value stocks are on the outs.

Index funds' consistency makes them ideal building blocks for creating a diversified portfolio that contains all sizes of stocks, styles of investing and different types of bonds as well. As if that's not enough, index funds tend to be tax-efficient, which is a fancy way of saying they generally give up less of their gains to taxes.

Unlike actively managed funds whose trading can generate realized gains that must be passed on to shareholders and then taxed (assuming the fund isn't held in an IRA, 401(k) or other tax-advantaged account), index funds' buy-and-hold approach results in less trading and triggers fewer taxable distributions.

But he doesn't recommend index funds for 100% of your investing needs (neither do I):

But as much as I love index funds - and think most people would improve their prospects by taking an index-funds-only approach - I'm not such a purist that I think you would be sabotaging your financial future by deciding to put a bit of your money into actively managed funds.

There are some managers who have special insights in some areas and have a chance to add value beyond what they charge in fees. Granted, I think it's a small minority of managers who can do this over long periods of time. I also think it's extremely difficult to identify those managers in advance. I can understand that some people want a shot at market-beating performance with a portion of their savings.

My advice, though, would be to keep that portion relatively small and make index funds your core holdings. If you do invest in actively managed funds, I'd also recommend that you stick with ones with relatively low expenses. And while past success certainly doesn't guarantee more of the same in the future, I'd still prefer managers with a solid record of achievement over a variety of different market cycles.

I've listed all the reasons I like index funds in my post titled Why I Like Index Funds. Check it out if you'd like more information on why I think they make a great investment for the long term.

See, I told you that you'd know how it would turn out. ;-)

Comments

[Dave]

What if your fund manager leaves for another firm? That is what happened to me after after stellar returns for 10 years!

[christianPF]

It is just amazing that in this industry 85% of fund managers fail to perform as well as the index. I have some of both, but there is such a huge case for choosing index funds.

[Matt]

Dave: Even if your fund manager hadn't left for another firm, his luck would have run out sooner or later anyway. Trying to find the right manager is like trying to find the right person to stake at a craps table. Stock picking is simply not a skill.

http://www.ifa.com/12steps/step5/

[Sabel]

Question for those in the know - what are the comparative financial benefits (if any) between a managed education fund (with education tax benefits) and a conventional managed fund. My initial research has shown that there are swings and roundabouts for each, however, I have not found a comparative analysis anywhere to assist in making a completely informed decision?
Has anyone experience in this area?