The eagerness to "beat the average" has lead many investors to invest in actively-managed funds instead of a more practical, common sense approach; low-cost passive index funds. Research has shown that only 24% of active mutual fund managers outperform their index benchmarks.
John Bogle, Founder of Vanguard, has the right idea. His philosophy is to hold low-cost index funds for the long-term, and history has proven him right. Vanguard offers low-cost index funds that mimic the broad market such as Vanguard Total Market ETF (NYSEARCA:VTI) and Vanguard Value (NYSEARCA:VTV), among other mutual funds and ETFs classified by sector and market-cap.
Countless studies have backed up Mr. Bogle's philosophy and point of view.
Researchers at Portfolio Solutions and Betterment conducted a study that found index fund portfolios outperformed comparable actively managed portfolios a staggering 82% to 90% of the time, based on advanced portfolios holding 10 asset classes between 1997 and 2012. The study outlined three key advantages passive index funds have over actively managed funds:
1. Portfolio advantage: Index funds have a higher probability of outperforming actively managed funds when combined together in a portfolio.
2. Time advantage: The probability of index fund portfolio outperformance increased when the time period was extended from 5 years to 15 years.
3. Active manager diversification disadvantage: The probability of index fund portfolio outperformance increased when two or more actively managed funds were held in each asset class.
S&P Dow Jones Indices recently published its scorecard of S&P indices versus active funds (SPIVA). "According to the figures, 55.8% of large-cap managers and 68.09% of small-cap managers underperformed the benchmarks over the past 12 months ending Dec. 31, 2013," said Aye Soe, director of index research and design. "The picture is equally unfavorable when reviewing the performance over the longer-term three- and five-year investment horizons. The results show that the majority of the active managers across all the domestic equities categories failed to deliver returns higher than their respective benchmarks."
In 2012, a British Paper called "The Observer" conducted a contest between three parties to select stocks within the FTSE All-Share Index. The three parties were a team of professional money managers, a team of school children, and a house-cat. "While the professional managers used their decades of investment knowledge and traditional stock-picking methods, the cat selected stocks by throwing his favorite toy mouse on a grid of numbers allocated to different companies." It turns out, the Cat won the contest, the professional managers came in second, and the school children came in third. These results support the idea that share prices move completely at random, making stock movements entirely unpredictable.
In 2008, Warren Buffett put his money behind his long-held argument that "experts" don't do better than the stock market as a whole. It's the basis of his argument that the fees "helpers" charge investors usually aren't justified. Warren Buffett made a decade-long bet with Protege Partners, an investment firm based on New York City. They would each select a fund (or group of funds), and find out which would perform better after ten years passed. Buffett selected, Vanguard 500 Index Fund Admiral Shares (MUTF:VFIAX). Protege Partners selected a collection of five hedge funds whose names have not been disclosed. Six years into the bet, Buffett's selection is up 43.8%, while the average of the five hedge funds are only up 12.5%. Buffett has an enormous lead, and even has his opponent admitting it; Protégé's Ted Seides said, "We've got our work cut out for us." Originally, the prize for this bet was $1 million in bonds. However, the two sides agreed to sell the bonds and buy Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B), stock with the proceeds, now worth over $1.3 million. While the two sides disagree on the passive vs managed fund debate, they appear to have found some common ground with a favorable view on Berkshire Hathaway, at least as an alternative to bonds.
Conclusion: The fees that are charged by actively-managed funds are simply not justified because they usually do not lead to a higher return. In fact, even if the fees did not exist, it still wouldn't be wise to invest in an actively-managed fund over an index fund. Index funds have performed better for a strong majority of the time, and they have the historical data to back them up.
Having a manager making buy and sell decisions doesn't guarantee you better performance. Instead, statistically speaking, it would appear that it actually lowers your odds of achieving better performance.
I have certainly reached a conclusion that passive index funds are a better alternative to actively-managed funds any way you look at it. However, I am not necessarily opposed to the idea of stock-picking if it is done in a passive manner; holding for the long-term. Selecting high quality individual stocks for the long-term without paying any fees may be a practical way to invest; it worked for Berkshire Hathaway investors.
Disclosure: The author is long BRK.B, SPY, VTV, VTI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.