Low Odds Of High Returns With Active Funds
Mutual fund investors have a choice: invest in a portfolio of low-cost index funds or a portfolio of actively managed funds that attempt the beat the markets. What should an investor do? According to a new white paper on the subject, the odds favor an all index fund portfolio.
The success of investing in individual asset categories by using low-cost index funds has been widely documented. However, surprisingly little research has compared the performance of diversified portfolios of index funds with portfolios of actively managed funds.
Rick Ferri, founder of Portfolio Solutions®, recently co-authored a detailed white paper on index fund portfolio investing with Alex Benke of Betterment. A Case For Index Fund Portfolios digs deep into portfolio returns and compares an all index fund portfolio to the returns of thousands of all actively managed fund portfolios. They found significant evidence in support of investing using an all index fund portfolio under multiple scenarios.
Their research is unique in that they used actual returns from mutual funds available to all investors throughout the study. Every portfolio was formed using the CRSP Survivor-Bias-Free US Mutual Fund Database that includes funds that have failed or merged over the years. This robust database enabled the researchers to replicate the real-world experiences of investors who could not forecast which funds would survive at the time they made their investment selections.
Here are some of important findings:
- 4 out of 5 actively managed fund portfolios underperformed all index fund portfolios in all scenarios tested.
- Diversification of active funds within asset classes (portfolios holding two or more active funds in the same asset class) reduced a portfolio’s performance dramatically, with the index strategy outperforming 9 out of 10 of these portfolios.
- Increased holding period increased the chance of index fund portfolio out-performance.
- Low-fee actively managed fund portfolios did not meaningfully increase the chance of success.
This study has important implications for all investors who wish to accumulate and maintain wealth. The study quantitatively demonstrates that an all index fund portfolio provides investors with a better chance for investment success.
A diversified portfolio holding only index funds in all asset classes is difficult to beat in the short-term and becomes more difficult to beat over time. Investors who hold actively managed fund portfolios can increase their probability of meeting their financial goals by switching to all index funds, and those who own two or more actively managed funds in each asset class would benefit even more by switching.