Q. Please explain the difference between a managed mutual fund and an indexed mutual fund. ---E.E., College Station, Texas
A. An individual or a committee manages a traditional mutual fun. They have the responsibility for decisions to buy or sell individual stocks or bonds. They sell stocks thought overvalued. They buy stocks thought undervalued. The same applies to bonds. In most investment companies a staff of researchers helps the manager in decisions. The cost of doing this is large.
An index fund is a portfolio that attempts to duplicate the performance of an index. The Standard and Poor’s 500 is the best-known index. It represents a broad selection of the largest publicly held companies in the United States. Together, they represent about 80 percent of all stock market capitalization in the US.
But there are many other indexes representing different parts of the market. There are also indexes for the entire bond market or different parts of it. Creating an index fund and tracking an index closely takes some work. But the cost is much lower than having a crew of expensive analysts.
Since the late 1960s research has shown, again and again, that most managed funds fail to beat the index they are pitted against. The fail rate is about 70 percent. That’s why I stopped interviewing mutual fund portfolio managers more than 20 years ago. It's why I started to focus on how readers could build their financial futures with low-cost index funds.
Q. I was well into investing in our retirement plan before "indexing" existed and before research proved its value. I am 82 years old. It is well past time to simplify our portfolio. It is with Fidelity.
We hold 55 percent equities and 45 percent bonds. The equities are large cap (3 funds) and mid or small cap (3 funds). There are 7 bond funds.
I can change equities to 1) the S&P 500 Index, 2) the Extended Market Index and 3) International Stock Index. There doesn't seem to be a comparable Bond Index. Help! Suggestions? ---R.F., by email
A. Yes, simplification would be good. It’s also likely, as many studies have shown, to provide a higher long-term return. There is no evidence that a portfolio of 13 different managed funds is beneficial.
The most recent research for this comes from researchers Richard Ferri and Alex Benke. They show that a three-index fund portfolio is likely to beat a portfolio of three managed funds. Over a 16-year period, 1997 to 2012, they pitted a simple three-index fund portfolio against randomly chosen managed funds. They did 5,000 simulations.
The result? The index fund portfolio beat the active portfolios 82.9 percent of the time. Some active portfolios beat the index. But the median advantage was only 0.52 percent. The far larger group of actively managed funds trailed the index portfolio by a median 1.25 percent. So the odds of beating the index were poor. And the reward, if it happened, was small compared to the more likely performance loss.
The researchers used three Vanguard funds: 40 percent in Vanguard Total Stock Market Index (ticker: VTSX), 20 percent in Vanguard Total International Stock Index (ticker: VGTSX), and 40 percent in Vanguard Total Bond Market Index, (ticker, VBMFX). The 60/40 stocks/bonds allocation is close to your 55/45. (These tickers are for the $3,000 minimum investment investor shares, but lower expense Admiral shares and ETF shares are also available.)
The even better news is that you don’t need to leave Fidelity to build the same portfolio. Instead, you can reinvest your sales proceeds in these three funds: Fidelity Total Market Index Premium (ticker: FSTVX), Fidelity Total International Index Premium (ticker: FTIPX) and Fidelity US Bond Index Premium (ticker: FSITX). All three funds have expense ratios that are a bit lower than the comparable Vanguard mutual fund.
But before you go full speed ahead on simplifying you should check how much you have in unrealized capital gains. Depending on your other sources of income, you might want to delay realizing some gains. You might also want to make a charitable gift of some shares to offset gains realized on other shares. Don’t be shy about visiting with your tax accountant.=
Scott Burns is the retired Chief Investment Officer of AssetBuilder, the creator of Couch Potato investing, and a personal finance columnist with decades of experience.