Make Twice As Much Money With Index Funds
January 23, 2017

Make Twice As Much Money With Index Funds

Matthew Backus’ financial advisor likes actively managed mutual funds. Last year, he reviewed Matthew’s portfolio. “These funds have dropped in value,” he said. “Let’s sell these funds and buy you something better.”

Matthew trusted his advisor. He was always on the ball. If one of his funds wasn’t performing, he advised that they sell it. That's what many people do. But the strategy is silly.

In fact, over a 30-year investment period, Matthew could retire with almost twice as much money if he invested with low-cost index funds. At first, that might sound crazy. But let me show you that it isn’t.

First of all, some actively managed funds do beat index funds. But without a working crystal ball, they’re tough to find ahead of time. Financial advisors can’t forecast which funds will win. Financial analysts can’t either. Even the actively managed funds with strong track records eventually disappoint.

But let’s get back to my claim. Index fund investors could retire with almost twice as much money. There are two reasons for that. First, actively managed funds cost more. That’s why most of them lose to index funds.

The SPIVA Persistence Scorecard shows that most active funds fall short. During the 10-year period ending June 30, 2016, the S&P 500 beat 87.47 percent of actively managed funds large-cap funds. The mid-cap index beat 91.27 percent of actively managed mid-cap funds. The U.S. small-cap index beat 90.75 percent of actively managed small-cap funds.

The SPIVA U.S. Scorecard puts actively managed funds to the test. Over the 10-year period ending December 31, 2015 the typical actively managed fund fell about 1 percent short of its equivalent index. Over a 30-year period, that would make a big difference. It would give the index fund investor about 33 percent more.

But there’s more to the story. Matthew Backus used to jump in and out of funds. His financial advisor said he should. When his fund selections didn’t do well, he always made a switch. Cruelly, his funds often languished after he bought them. Other funds performed well, but after he convinced Matthew to sell. This is pretty common.

In June 2016, Morningstar published Mind The Gap, Active Versus Passive Edition. Here’s what they were looking for. They examined the performances of funds in different categories. For example, when they looked at actively managed Large Cap Growth funds, they averaged a compound annual return of 7.07 percent per year for the 10-year period that ended December 31, 2015. But the typical investor in those same funds averaged a compound annual return that was 1.21 percent less than that per year.

There’s only one explanation. Like Matthew’s advisor, they invested more money in funds that had recently done well. They invested less money (or even sold) funds with poor recent returns. But funds that do well during one time period often lag the next. As a result, investors often buy high and sell low.

Morningstar says that investors in actively managed funds do this a lot. They hope to beat the market. Their belief in active management puts them on a never-ending quest for the next hot hand.

But index fund investors have a lot more discipline. Most admit that they can’t forecast winning funds or predict where stocks are headed. As a result, they do far less trading and market timing. Sometimes, by dollar cost averaging, they even beat the posted performances of their index funds.

I looked at SPIVA’s report ending December 31, 2015 to see how actively managed fund performances compared to their benchmark indexes. I then cross-referenced that data with Morningstar’s Mind The Gap, Active Versus Passive Edition. Both reports measured the same time period. Index fund investors were indeed more disciplined.

When comparing seven different equity classes, I found that index fund investors beat investors in actively managed funds by a whopping 2.39 percent per year during the 10- year period ending December 31, 2015.

The typical investor in actively managed funds turned $10,000 into $17,606. Index fund investors turned the same $10,000 into $22,176. High fees and poor human decisions will likely continue to hurt active fund investors.

That’s why index fund investors could retire with a lot more money. Suppose, for instance, that the performance figures just cited continued for 30 years. The index fund investment would grow to $106,664 while the managed fund would grow to $54,579, about half as much.

That’s why Matthew Backus recently fired his advisor. “I won’t let anyone mess with my money anymore,” he says. “I’m sticking to a low-cost portfolio of index funds.”

Index Fund Investors Win
December 31, 2005-December 31, 2015

Fund Return Behavioral Influence Investors’ Annual Return 10 Year Investors’ growth of $10,000 30 Year Investors’ growth of $10,000*
S&P 500 Index 7.31% +0.98% 8.29% $22,176 $109,056
Actively Managed Large-Cap Funds 6.48% -1.18% 5.30% $16,760 $47,081
S&P 500 Value Index 5.80% +0.17% 5.97% $17,857 $56,949
Actively Managed Large-Cap Value Funds 5.90% -1.16% 4.74% $15,890 $40,121
S&P 500 Growth Index 8.70% -0.61% 8.09% $21,769 $103,172
Large-Cap Growth Funds 7.07% -1.21% 5.86% $17,673 $55,202
S&P Mid- Cap 400 Index 8.18% +0.58% 8.76% $23,157 $124,186
Average Actively Managed Mid- Cap Funds 7.26% -0.61% 6.65% $19,037 $68,996
S&P Mid-Cap 400 Value Index 7.42% 0% 7.42% $20,457 $85,615
Mid-Cap Value Funds 6.72% -1.06% 5.66% $17,342 $52,157
Small Growth Index 8.81% +1.32% 10.13% $26,245 $180,787
Average Actively Managed Small Growth Fund 7.43% -0.69% 6.74% $19,198 $70,764
S&P Small- Cap 600 Value Index 7.17% +1.64% 8.81% $23,264 $125,911
Small-Cap Value Funds 6.08% -0.27% 5.81% $17,590 $54,425
Index Fund Average 7.62% +0.44% 8.21% $22,012 $106,664
Actively Managed Average 6.70% -0.88% 5.82% $17,606 $54,579

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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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