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Index Funds Beat the Competition

As the year comes to a close, it’s time to recognize the market winners and losers. Call it a landslide victory. Research shows index funds outperformed actively managed funds by a far margin in 2014:

  • According to Wharton Research Data Services at the University of Pennsylvania, only 9.3% of mutual funds that invest in large U.S. stocks such as those in the S&P 500 beat the index through September 30.
  • Bank of America found 82% of active fund managers underperformed their benchmark indexes through October – a 10-year low.
  • In the midyear report of Standard & Poor’s active-versus-passive scorecard, 60% of large-cap managers, 58% of mid-cap managers and 73% of small-cap managers failed to beat their benchmarks over a one-year period ending June 30.

In 2014, you would have been better off in index funds rather than active funds. And, many investors were in index funds. According to Morningstar, passive investments accounted for 68% of all net cash inflows over 12 months ending June 30.

Index funds won’t win every time

Of course, this doesn’t mean it’s time to take a victory lap. The only time for that is when you reach your financial goals.

Markets fluctuate constantly and active fund managers can have periods of outperformance. As they say, even a blind squirrel finds a nut once in a while.

Consider that multi-cap value and real estate fund managers did beat their benchmarks in the same S&P study referenced above. While this shows index investing doesn’t always win – nothing does or will – it’s also an indication of how improbable it is for an investor to successfully pick in advance what asset classes or fund managers will come out on top.

Understanding the difficulty to choose market winners and losers can help you avoid poor investment decisions. Your behavior affects your returns as much as your strategy. Dalbar’s 2014 Quantitative Analysis of Investor Behavior found the average investor trailed the S&P 500 by 7.42% annually over the past 30 years ending December 31, 2013. That’s why you should stick with your investment strategy through ups and downs.

Increasing your odds to win

In any given year, you can improve the probability of meeting your financial goals by maintaining a broadly diversified portfolio, keeping investment costs low, and rebalancing your portfolio.

Diversification protects you from the high risk that comes with attempting to choose a market winner, whether from market timing or stock picking. Investing across several asset classes spreads risk in your portfolio. You may not hit home runs, but you’re less likely to take a beating. Steadier returns may also increase the likelihood you won’t change course when seas get choppy.

A major reason active funds fail to beat their benchmarks is cost. In order for you to reap the earnings of an active fund, the manager has to beat the market by a margin greater than the fund’s cost. Consider that the average active fund expense ratio is seven times more than the average index fund, according to the Investment Company Institute. A low-cost index fund lets you keep more of what you earn.

Index funds may not win every yearly battle, but in the long run they have a higher probability of winning the war.