Now that we have established the fundamental differences between Index Funds and Actively Managed funds (Investing basics can be found here). Index Funds match the returns of the benchmarks or specific stock market tracking. While Actively Managed funds try to outperform the benchmarks.
Outperforming the stock market sounds great doesn’t it! According to Investopedia.com many actively managed funds struggle to keep up with Index funds. How much of a struggle? In a five year period ending in 2015, 84% of the large cap actively managed funds failed to beat their S&P 500 Index counterparts. In a ten year period also ending in 2015, 82% failed to beat the Index! Don’t take my word for it. Take Warren Buffet’s!
In 2008 Warren Buffet (investing genius) made a bet with Protege Partners investing firm that in the next ten year period that a Vanguard S&P 500 Index Fund would outperform Protege Partners actively managed fund picks. As of 2016 Vanguard S&P 500 Index Fund is up 65.67% while the actively managed fund picks are up 21.87%. Wow a 43.8% difference, just wow. By the way if you take into consideration fees the average actively managed fund is debiting your account 1.25%, while S&P 500 Index Funds average 0.15%!
Actively Managed Fund: 1.25% average annual fee is essentially paying a brain trust of managers to try to outperform the stock market which just over 80% of the time does NOT happen.
Index Fund: 0.15% average annual fee is essentially paying a computer to track the market (benchmark) and match the returns the market gives. Index investing = buying the stock market, not trying to beat it and paying high fees to lose!
Once again don’t take my word for it! Look at your options for your 401k, 457b, or 403b. Typically they will break them down by asset class large cap, mid cap, small cap, or international. Pick a category, most likely you will see an Index Fund option as well as an actively managed one. Click on the prospectus and compare the one year, five year, and ten year returns. There is also “since inception” returns but beware as the inception date may be significantly different from fund to fund. I am almost 100% positive by paying attention and investigating this you will see that the Index Fund is far superior! You may also see that your financial adviser does not have you in a low fee index fund… hmm wonder why?
Below is an example of two funds that I have access to in my Deferred Compensation Plan (457b):
Virtus Ceredex Large-Cap Value Equity Fund Class I (STVTX):
Expense Ratio = 0.97%
One year = 16.91% return
Five year = 13.08% return
Ten year = 6.88% return
Vanguard Total Stock Market Index Fund Institutional Shares (VITSX):
Expense Ratio = 0.04%
One year = 18.64% return
Five year = 14.19% return
Ten year = 7.7% return
Both of the above funds are Large Cap funds. The one, five, and ten year return does not take into account the annual expense ratio! Clearly the Index alternative beats the other option available to me without even considering fees! For my work sponsored 457b they did a very nice job in limiting fees and giving a pretty good list of investments. When you go outside of work sponsored plans i.e. Roth IRAs and taxable accounts you have almost endless choices. The coworker I talked about in “It’s all Greek to me” went to a financial adviser that put him in front-load funds (stay away!) and expensive actively managed funds. Of the funds he was in NOT ONE beat any return of the Vanguard Total Stock Index Fund. For example the below actively managed fund.
Goldman Sachs Growth Strategy Portfolio Class A (GGSAX):
Expense Ratio = 1.38%
One year = 16.72% return
Five year = 8.85% return
Ten year = 4.93% return
This Goldman Sachs Large Cap Fund has severely under-performed the option of a Vanguard Total Stock Index Fund and with a 1.38% Expense Ratio to boot! The 2% to 5.5% Front Load fee on initial investment is not even calculated in these returns! Over-pay much for low returns? I think so and so does the math!
The above examples are a small sample size of available options out there for both actively managed and index funds. However, this small example illuminates the superior advantage of Index Funds and Passive Investing. If you are comfortable with low returns and high fees so be it, especially if it helps you sleep at night that someone is out there attempting (most likely failing) to beat the market. If the latter is you, then just at least know what you’re paying. Many individuals out there have no idea what their money is invested in or what they are paying for it. Look into your portfolio and PAY ATTENTION!