endowments, and pension funds with $1 billion or more in invested assets. By amateurs, I’m talking about the average U.S. investor with a few assorted and sundry mutual funds in his 401(k).
Let’s compare the two: During the 20-year period 1990 through 2009, the U.S. stock market, as measured by the S&P 500 Index, provided an annual rate of return of 8.2 percent. Yet the average stock mutual fund investor, according to a study by Dalbar, earned an annual rate of 3.2 percent over that same period, just barely keeping up with the inflation rate of 2.8 percent a year. Bond-fund investors did much worse. Why the pitiful returns? There are several reasons, but two main ones:
✔ Mutual fund investors pay too much for their investments.
✔ They jump into hot funds in hot sectors when they’re hot and jump out when those funds or sectors turn cold. (In other words, they are constantly buying high and selling low.)
Professionals tend not to do either of those things. To give you an idea of the difference between amateurs and professionals, consider this: For that very same 20-year period in which the average stock mutual fund investor earned 3.2 percent, and the average bond mutual fund investor earned 1 percent, the multibillion-dollar stock-and-bond-and-real-estate California Public Employees’ Retirement System (CALPERS) pension fund, the largest in the nation, earned nearly 8 percent a year.
Professional managers, you see, don’t pay high expenses. They don’t jump in and out of funds. They know that they need to diversify. They tend to buy indexes. They know exactly what they own. And they know that asset allocation, not stock picking, is what drives long-term investment results. In short, they do all the things that an ETF portfolio can do for you. So do it. Well, maybe … but first read the rest of this chapter!
Passive versus Active Investing: Your Choice
Surely, you’ve sensed by now my preference for index funds over actively managed funds. Until recently, all ETFs were index funds. And in the past few years, most index funds have been ETFs.
On March 25, 2008, Bear Stearns introduced an actively managed ETF: the Current Yield ETF (YYY). As fate would have it, Bear Stearns was just about to go under, and when it did, the first actively managed ETF went with it. Prophetic? Perhaps. In the years since, about 130 actively managed ETFs, from 29 providers, have hit the street, with quite modest commercial success. But time will tell… .
I don’t think this development is necessarily a bad thing, but I’m not frothing at the mouth to invest in actively managed ETFs, either.
In the next few sections, I look at a few of the pros and cons.
The superior returns of indexed mutual funds and ETFs over actively managed funds have had much to do with the popularity of ETFs to date. Index funds (which buy and hold a fixed collection of stocks or bonds) consistently outperform actively managed funds. One study done by Fulcrum Financial tracked mutual fund performance over ten years and found that 81 percent of value funds underperformed the indexes, as did 63 percent of growth funds. And that is just one of many, many studies that present similar results.
Here are some reasons that index funds (both mutual funds and ETFs) are hard to beat:
✔ They typically carry much lower management fees, sales loads, or redemption charges.
✔ Hidden costs – trading costs and spread costs – are much lower when turnover is low.
✔ They don’t have cash sitting around idle (as the manager waits for what he thinks is the right time to enter the market).
✔ They are more – sometimes much more – tax efficient.
✔ They are more “transparent” – you know exactly what securities you are investing in.
According to Morningstar data as interpreted by Investment News, nearly 28 percent of all large cap funds carry a three-year R squared of 0.95 or higher relative to the S&P 500 stock index. That kind of number makes them closet index funds. And if you look at the entire mutual fund industry, it is apparent that the triumph of indexing is becoming well known. Recently, the average large cap fund had an R squared of almost 0.90. That number is up from 0.74 only a decade or so ago.
Speaking in broad generalities, actively managed mutual funds have been no friend to the small investor. Their dominance remains a testament to people’s ignorance of the facts and the enormous amount of money spent on (often deceptive) advertising and PR that give investors the false impression that buying this fund or that fund will lead to instant wealth. The media often plays into this nonsense with splashy headlines, designed to sell magazine copies or attract viewers, that promise to reveal which funds or managers are currently the best.
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