Overview of Key Terms
Index funds attempt to closely mirror performance of the total market or market sector with passive management. Actively managed funds attempt to outperform a market after accounting for expenses. Fund managers charge for their management, and in turn raise the gross expense ratio of the fund. Actively managed funds tend to have considerably higher expense ratios than passive index funds. We’ll break down why it matters.
Active vs Passive Management
Consider a higher expense ratio as compensation for a hedge fund, mutual fund, pension fund managers etc. professional savvy. We would assume fund managers who have spent years studying markets, would have an edge over the layman investor. In theory their expertise should allow opportunity to outperform standard market growth. Historical evidence have shown this simply isn’t true.
Financial analysts Richard Ferri and Alex Benke found index fund portfolios outperformed comparable actively managed portfolios 82% to 90% of the time over the course of 1997 to 2012.
Their white paper study, A Case for Index Fund Portfolios, provides evidence index fund portfolios are outperforming actively managed portfolios more often than originally believed. Summarized are their three core reasons for superior index fund performance.
1) Portfolio advantage: Index funds have a higher probability of outperforming actively managed funds when combined together in a portfolio.
Translation – Possessing a portfolio of index tracking funds, rather than a singular index fund, amplifies the likelihood of outperforming actively managed portfolios.
2) Time: The probability of index fund portfolio outperformance increased when the time period was extended from 5 years to 15 years.
Translation – As the we consider a longer time horizon for investing, expense ratios comes into play. Expense ratios are determined by the managers and are based off of total assets managed. An expense ratio of 1% of a one billion dollar fund means $10,000,000 are going to managers yearly. That means $10,000,000 less to be invested and returned to equity holders. The effect compounds over time.
3) Active manager diversification disadvantage: The probability of index fund portfolio outperformance increased when two or more actively managed funds were held in each asset class.
Translation – Ferri and Benke refer to asset classes as equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). This again emphasizes the value of diversity in a portfolio.
The outcome of the study statistically favors an all-index fund strategy, all the time and deepens evidence that an all-index fund portfolio is difficult to beat. A graph provided by Vanguard and Morningstar plots excess returns relative to the S&P 500 Index vs fund expense ratio.
I’m sure some fund managers have been able to outperform the market, but those elite managers are a minority. The passive vs. active management results have practical implications for any investor trying to maximize returns, especially over a time horizon greater than a few years years.
The next logical step is finding a low-cost and secure index tracking fund. Off the top of my head Schwab and Vanguard (SCHG and VOO) offer some of the best options.