Active vs. Passive Investing
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Because our income is in no way tied to the type or amount of investments that our clients have, we are free to explore all the investment options across the vast investing universe to choose the the best options for our clients.
Today we want to focus on the difference between using higher cost actively managed investments versus lower cost index funds or exchange traded funds (ETF)s.
Actively managed mutual funds are investments that use highly paid fund managers to pick the stocks or investments they think will perform the best.
Using managers means that mutual funds have to charge their customers higher fees in order to pay the mutual fund company, the mutual fund manager, etc. The expense ratio (percentage of the portfolio that’s charged as a fee each year) for a mutual fund can be anywhere from around 1% to 2.5%.
For example, if your $100,000 portfolio had an expense ratio of 2%, you would be paying $2,000 each year just to hang onto that mutual fund. For this fee you receive a diversified basket of investments that are chosen for you by the mutual fund manager.
The mutual fund manager is also making continuous changes in this portfolio within the constraints of the fund prospectus. The goal of these changes are to improve performance, reduce risk, or enhance income.
Passive index funds or exchange traded funds (ETF)s attempt to mirror an entire sector of the market by matching the returns of a market benchmark, such as the S&P 500. The S&P 500 is a collection of stocks from the 500 largest companies in the United States that is meant to act as an indicator of how the market is performing as a whole.
Matching a benchmark can be done at a very low cost using computer algorithms, allowing index funds and ETFs to have much lower expense ratios, typically ranging from 0.00%(!) to 0.20%. In this case, with an expense ratio of 0.10%, you will only be paying $100 per year on a $100,000 portfolio.
Like with mutual funds, you are buying a diversified investment. Because it is not actively managed, there are not changes being made to the investment like you would see with a mutual fund. But the question is, does this additional management justify the higher cost?
So, how do actively managed mutual funds justify their much higher cost?
They argue that their active management outperforms the associated index, such as the S&P 500, enough to make up the difference in cost. However, the data does not support this claim.
A 2018 report from Morningstar, one of the largest investment research firms in the world, showed that only 13.4% of large-cap mutual funds both survived and outperformed the market index when accounting for their fees over the past 20 years.
You may be thinking, “13.4% isn’t much, but it still means that some actively managed mutual funds did outperform the index.” While this is true, one of the most overlooked statements in any investment report is that “past performance is not a guarantee of future performance.”
A study published in the Journal of Economic Behavior & Organization in 2019 showed that predicting individual mutual funds that will outperform the index is almost impossible because luck plays a significant factor when it comes to picking stocks.
This study analyzed 2,469 actively managed mutual funds from 1984-2015 and found that only 0.8% of the funds demonstrated any skill at picking stocks to beat their respective index when accounting for false discoveries (a.k.a. luck).