Here's 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!!!!! Let's 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.
- "While index fund expenses average just .69% of assets." Perhaps this is the average, but still way too high IMO.
- "Some of the best-known S&P 500 index funds charge less than 0.2%." Pretty good, but we can do better (as I'll show in a minute.)
- "A large-cap manager must beat the market by more than a full percentage point to merely equal the return of the index." Think 1% isn't a big deal? Try plugging in a 6% return instead of a 7% return in any retirement calculator and see just how big a deal 1% is.
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
- Vanguard Total Bond Market Index Admiral (VBTLX) -- 0.11% expense ratio
- Vanguard Total International Stock Index Admiral (VTIAX) -- 0.20% 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.) That's just the point -- and that's 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 doesn't mean most people can. If you don't believe me, check out the details behind why I invest like I do.
Even more good news -- Vanguard just lowered the expense ratio on VTIAX two basis points to 0.18%!
Posted by: Bill | March 21, 2012 at 08:02 AM
>Why do so many individuals gravitate to actively managed funds when they are a proven loser?
I can think of two answers: Virtually all fund advertising and sales efforts are for actively managed funds. Also, there is the greed factor- people think they can pick the winning fund (or worse stock) easily when it is much harder than they think.
-Rick Francis
Posted by: Rick Francis | March 21, 2012 at 08:18 AM
I'm sure financial advisers are playing a part by pushing people towards the option where they might get the better commission. The less knowledgeable investor might assume that the index funds are the safe bet while actively managed funds might have the potential to earn more money if they luck out.
Posted by: Modest Money | March 21, 2012 at 08:51 AM
I finally got around to watching "Inside Job" last night and it's put me in a financial funk.
If even half of what that movie claims is true then the whole market is rigged and buy & hold is dead as a long-term investing strategy. The markets have changed so dramatically in the last decade that all statistics predicting long-term gains going forward are meaningless.
Posted by: MonkeyMonk | March 21, 2012 at 09:21 AM
I had to look back at my Vanguard portfolio... only 1/6 index funds. However, Vanguard closes the gap between index and active management -- the majority of their active funds are around .5% or less, with index funds around .2%. So the gap is definitely smaller, especially with some of their well established funds like Wellesley, which is only .25%.
But I agree with the main principle. Keep an eye on expenses and performance compared to the index fund.
Posted by: Daniel | March 21, 2012 at 09:48 AM
@MonkeyMonk
I haven't seen Inside Job but I don't see how the financial industry can rig the value of the entire stock market. Yes there are bubbles where stock prices are out of whack- but did Wall Street create the tech bubble or just take advantage of it?
Rated investments like bonds or CDOs can be fraudulently rated but eventually the real ratings come to light and the value adjusts accordingly. If a ranking agency consistently commits fraud then who is going to believe them in the future?
-Rick Francis
Posted by: Rick Francis | March 21, 2012 at 10:45 AM
Hey Free Money, I read that article and was curious as to how ETF's stack up but haven't seen anything-How about you?
Posted by: Steve Mertz | March 21, 2012 at 10:49 AM
One thought: A significant amount of investment occurs via 401k plans/tax-advantaged space, which typically have very limited choices--especially at smaller companies. Between my plan and my husband's, we have a total of 3 index fund options: S&P 500 and two small-cap indexed funds...all of which have ERs of 0.5-0.8 (partly due to AMC fees). Granted, n=2, but I don't think we're alone in having limited ability to select a low-cost index fund--even though we would prefer to do so given the choice.
Posted by: AN | March 21, 2012 at 10:49 AM
Good point AN. I was just reviewing my 403b, I have one index option - an S&P 500. I've been in a small cap because I liked the historic returns, but it's 1.41% expense -- yikes. I just decided to dump it and go with the 500 fund at 0.25% because the returns are comparable. I will have to use my Vanguard IRA to balance around it, because most of the other 403b options are mediocre funds with 0.6-1.2 expenses.
This is the real crime -- terrible employer sponsored plan options. But it looks like my 403b investment firm (AUL) gets a cut from the mutual fund, so I guess there's little incentive for index funds where the profit is low.
Posted by: Daniel | March 21, 2012 at 10:59 AM
I'm a big fan of the Vanguard funds, too. Even ones that are slightly more active than index funds have pretty low expense ratios.
Posted by: Nick | March 21, 2012 at 11:26 AM
Ugh. My 401k through work has just terrible choices -- all actively managed funds, some with fees around 2% and most averaging over 1.5%. The lowest fee is 0.68% and that's for a money market-type "low risk" fund with average returns under 1%. Right now I'm contributing the minimum to get the match from my company. Considering the awful options, am I better off investing extra cash in a non-retirement account through Vanguard? I already max out my Roth IRA, which is at Vanguard, but I'm worried that my only other retirement investment vehicle is this awful 401k through work. I am appealing to my boss to add more options to our current plan (if possible) or possibly switch to Vanguard/Fidelity, but it's a small company and in the past he hasn't been very receptive to changing it up, especially since it's managed through Paychex, which also does our payroll so it's easy for them. Any thoughts from the more experienced investors that read this site?
Posted by: SA | March 21, 2012 at 12:26 PM
Like Steve, I would love to see a comparison between ETF and index funds. For my money I perfer ETF. They trade like stocks which give you a huge advantage in todays market.
Posted by: Joe | March 21, 2012 at 12:34 PM
Index funds are great in terms of low costs. No question there. Index funds are certainly preferable to any managed large cap US fund.
But a portfolio of pure index funds is not suitable for every investor's needs. If you hold a major US index fund, you are really not that diversified - your money is disproportionately in a few large cap US stocks. You don't have fixed income, you don't have international exposure, and you have very limited exposure to mid cap and small cap stocks.
With that caveat, I agree, index funds are great.
Posted by: Bad_Brad | March 21, 2012 at 12:44 PM
My Roth is with Vanguard and is invested in their target date 2050 fund. The fund has an expense ratio of .19%. I will soon be opening a Roth for my wife with Vanguard as well. As far as expenses go, it seems very hard to beat Vanguard.
Posted by: CT | March 21, 2012 at 12:51 PM
In retirement many people, including myself, find a need for a mutual fund that only owns municipal bonds issued by municipalities in the state in which they file taxes. Municipal bonds are tax exempt federally but not by states. For example, Vanguard and most large brokerages or investment firms have a fund that only holds, in my case, California muni bonds. Keep that in mind when your retirement goal is to generate a lot of totally tax exempt interest.
Posted by: Old Limey | March 21, 2012 at 01:17 PM
Hooray for index funds! I'll take the lowest cost, plain vanilla index trackers held inside a tax free wrapper (ISA), with maybe a broad global diversification thanks (as long as charges stay low on the international funds). If you're drip-feeding into it monthly I've found it's hard to get hold of ultra low cost index funds in the UK, e.g. Vanguard. You need a bigger chunk of change to start with. Unless anyone can point me in the right direction?
Posted by: Drew | March 21, 2012 at 01:19 PM
I will never knock indexing. But the research shows that most people are actually pretty good at picking better than average mutual funds...sooo the statistics on the average performing fund don't tell the whole story. If you pick actively managed funds with below average expenses (below 1%), your chances of beating the S&P 500 index go up.
The main problem most people have, whether indexing or not, is not sticking with the funds they have through thick and thin.
That's why I'm still an advocate of investing in the better balanced funds, which own a mix of stock and bonds. People tend to stick with these for longer and get better performance as a result. Some of my favorites:
Vanguard Wellington (VWELX)
T. Rowe Price Capital Appreciation (PRWCX)
Oakmark Equity and Income (OAKBX)
Mairs and Power Balanced (MAPOX)
Not my favorite fund, but it's certainly a decent one for those who love indexing:
Vanguard Balanced Index (VBINX)
Posted by: Mark | March 21, 2012 at 01:55 PM
Steve --
I believe that the last time I checked the ETFs for those funds had the same expense ratios, PLUS there were transaction fees for buying and selling. I could be mistaken though...
Posted by: FMF | March 21, 2012 at 08:07 PM