It’s Twilight for Managed Mutual Funds
May 16, 2014

It’s Twilight for Managed Mutual Funds

It doesn’t matter how many pages of advertising they take out in the glossy financial magazines. Ditto how many minutes of ads they buy on television. It doesn’t even matter how many salespeople they send out disguised as financial advisers to sell their “good for them, not so good for you” products. Managed equity funds are on the way out. Today, low-cost index funds are what investors choose— for many good reasons.

This is not a prediction from your incorrigible index-investing columnist. And I’m not predicting this will happen in 2015 or 2020. It has already happened. In every year since 2006 managed equity funds have been in net redemption— shareholders are redeeming more shares than they are buying. Meanwhile, the opposite has happened with index based equity funds. In each year there has been a net inflow of new money, including fear ridden 2008.

The evidence comes from Morningstar’s 2013 Global Flows Report. A fairly cosmic picture of mutual funds around the world, a striking chart in the report shows steady inflows of new money to index-based stock funds and a mounting outflow from managed stock funds. Last year was a bit of a reprieve, the outflows diminished.

Another bit of evidence from the same report: Four of the five funds with the largest inflows of new money last year were index funds. Three are from Vanguard and one is from State Street. The State Street fund was their SPDR S&P 500 Index exchange-traded-fund. A pioneer in this rapidly growing investment venue, it didn’t exist until 1993. Today over $157 billion is invested in this single fund. Few entire mutual fund companies are this large.

Does this mean managed mutual funds are about to disappear? Hardly. The time scale for change in finance is slower than the time scale for technology. Index funds will not replace managed funds as quickly as the electronic hand calculator replaced the slide rule or as quickly as digital cameras replaced film cameras.

You can get some idea of the pace of change by considering a brief history. When I offered the first Couch Potato Portfolio in September 1991 there were only 28 index mutual funds. There were no exchange-traded funds, zero.  Only 5 index funds had been in operation more than 5 years.

Back then the only way to compare index-fund investing to managed-fund investing was to compare the performance of the actual indexes with the performance of actively managed funds. The result showed indexing was a good bet.

By 2000 there were 158 unique index mutual funds and exchange-traded funds. By 2010 there were 1,069. Today there are 1,911 individual index funds, many offered in multiple forms. Still, they have 7,173 managed funds to displace.

Functionally, index funds are to the managed mutual fund industry what the world-wide-web has been to the newspaper, music and book publishing industries. You can understand why this is happening by making a simple comparison. In his 13 page eBook on investing for Millennials, William S. Bernstein suggests a three part portfolio that is almost identical to my

Margarita Portfolio: One part domestic stock market, one part domestic bond market, and one part international stock market.

Today, this portfolio can be put together without commissions. Its annual expense will be a bit under 0.06 percent. Morningstar categorizes the comparable managed fund as a “moderate allocation” fund. Their database shows that the category has an average net annual expense ratio of 1.22 percent. This means you could manage your money in these low-cost exchange-traded funds for 20 years before you would spend as much at it will cost to manage the same money in a managed version of the same thing.

Yes, you read that right. You’ll spend as much in one year with a typical managed fund as you’ll spend in 20 years with its index-based replacement.

If you invested $1,000 a year in each fund and both provided the same 8 percent gross annual return before fees, your managed fund would grow to $188,658 in 40 years after fees. Your index fund would grow to $254,999. That’s a difference of $66,341. Every dime of that difference is money in your pocket, for your retirement.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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