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Five Wins for Index Funds

Index funds are a superior investment product to funds that try to beat the markets. Their low fees, low turnover, and broad diversification provide the highest probability for long-term success. An investor’s best chance for meeting a financial goal is a portfolio of low-cost index funds that is well allocated across multiple asset classes (Read All About Asset Allocation for more details).

Unless a person is very lucky at picking more expensive active funds, odds are they will have more money in the long-term by investing with 100 percent index funds. Here are five reasons why:

  1. Active management is higher risk. All mutual funds reflect either one or two risks. First, every fund reflects the risk and expected return of the market as a whole. This is systematic risk or beta. Index funds are 100 percent beta risk. In the end, all investors combined produce a market return. Actively managed accounts have a second risk called unsystematic risk or manager risk. Higher expected returns from active funds can only be earned through less diversification then the market or by trading the market. Since the cost of active management is much higher than the cost of indexing, and since all investors in aggregate get the market return, then the probability for beating the market is reduced by a factor of lower diversification and higher active management fees and trading costs.
  2. The higher cost of active management doesn’t buy much. A Morningstar analysis of all actively managed U.S. equity funds reveals that approximately 90 percent of return is related to systematic market factors and only 10 percent from active management strategies. The average expense ratio for low-cost equity index funds is 0.2 percent per year and the average expense ratio for active funds is 1.2 percent. The 1.0 percent per year extra fees for active management is a lot to pay considering fund performance is 90 percent related to beta and only 10 percent manager controlled.
  3. Most active funds disappear or underperform. During August 1976, the passive versus active debate moved from academia to Main Street and the battle for the hearts and minds of investors began. There were about 260 actively managed domestic equity funds available to investors at the time the Vanguard 500 Index Fund launched in late 1976, according to Lipper, a financial markets research company and wholly own subsidiary of Reuters Group PLC. More than half of those funds have closed or merged over the past 35 years, leaving 125 surviving funds as of July 2011. Typically, funds close or merge due to several periods of poor performance.
  4. Surviving funds have a low chance to beat the market. The average remaining 125 funds performed lower than the Vanguard 500 Index Fund. About 1 in 3 surviving funds beat the index fund and the other 2 underperformed the index fund. A 1:2 win-loss ratio is found to be a surprisingly consistent number throughout several decades of investing. With equity investing, only one surviving fund out of three outperforms, or 33 percent.  The odds are worse for bond funds. Only 20 percent of surviving bond fund tend to outperform their benchmarks.
  5. Winning funds don’t win by enough to justify the risk. The final strike against active funds is the small excess returns of the winning one-third of active funds relative to larger shortfall from the losing two-thirds. If the wining funds won by a lot, then it is worth taking the risk. However, analysis for The Power of Passive Investing shows that surviving winning funds outperform by about 1.0 percent on average, while the losing active funds fell short by about 1.7 percent on average.

In summary, the five strikes against active funds are higher risk, higher cost, lower survivability, low success in beating the market, and a low payout from winners relative to the losers. Indexing wins because active management losses — any way you look at it.