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  • Raisonné & Hammer Price

Index Investing is Not All It's Cracked Up to Be

“Most active fund managers don’t outperform the S&P 500, so you should just invest in the index.” Every investor has heard this line OR spoken it themselves. How many investors consider what “you should just invest in the index” really means for their returns and if it really is better to overlook actively managed mutual funds and ETFs?

The S&P Dow Jones Indices has created a division, SPIVA (S&P Indices vs Active) to track this active vs passive battle over time. The SPIVA research as of the end of 2017 showed that for the previous year almost 37% of active fund managers have beaten their benchmark.  Over a 3-year window it was about 20% and over 5 years it was nearly 16%. However, over the same time horizons essentially ZERO index ETFs or index mutual funds should beat their benchmark! 

That’s right…by buying into an index fund you are virtually GUARANTEEING your returns will underperform the benchmark. This truth boils down to a couple key points as follows:

1.   Taxes- In a taxable account Uncle Sam will take his cut on dividends and capital gains. While this is a consideration across all investment types, index ETFs and mutual funds are not going to incorporate any tax sensitive investment planning strategies which could keep more money in your pocket.

2.   Trading Costs- Index funds have to rebalance as markets move and trade as stocks are added are removed to an index. These commissions drag on performance.

3.   Fees and Expense ratios- Expense ratios can vary dramatically but there are also licensing fees to index providers when the name is used and administration fees to run the funds.

4.   Tracking Error- An index fund may not perfectly mirror its index. For example, a fund may only invest in a representative sample of the securities in the market index, in which case the fund’s performance may be less likely to match the index.

5.   Emotion- Most investors have a hard time staying invested through volatile periods and buy when the market is high. Dalbar Inc. has researched this phenomenon and found that investors drastically underperform the markets when left to self-manage. This is particularly true if you have not worked on a solid financial plan and strategy with someone you trust. Dalbar calculated that for the twenty years ending 12/31/2015, the S&P 500 Index averaged 9.85% a year. The average equity fund investor on the other hand, earned a market return of only 5.19%.

The charts below compare returns over the most recent 1, 3, 5 and 10-year trailing period for the S&P 500 as well as 2 index and 2 actively managed mutual funds. The index funds include the best and worst performing index funds over that 10-year period. The actively managed funds are in the large blend category and are a mid-range outperformer and the highest performing. The first chart looks at returns on a pre-tax basis and the second takes into consideration after-tax returns.

The charts clearly identify a few things. 

1.   No matter what, ALL S&P 500 index funds are destined to underperform the actual index.

2.   The index-fund an investor chooses matters a lot! Over 10 years the difference between the best and the worst was over $37,000!! Obviously not all index funds are created equal.

3.   If you want any chance at outperforming the S&P 500 you have to go with an active approach.

4.   Finding and investing with the right active manager can make a big difference in an investor’s returns. The low performing index fund underperformed the top active fund by 70%!! Over 10 years on an initial 100k investment this would make a difference of nearly $160,000.

While it is not easy to identify mutual funds and investment strategies that will outperform over the long run, the additional effort can make a huge impact on your portfolio value over time. Putting in the time to identify these managers and strategies or working with a trusted advisor that can help you tailor an appropriate approach for your financial situation can positively affect your quality of life for the long run.


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