Why Buy Anything But Index Funds?

by: Tom Mongan, CFA

Maybe it's the season, or the strong market for stocks that many investors have missed, but I have recently noticed a bunch of published comments advising folks to avoid actively managed funds. The sources are newspaper articles, index fund ads, even TV commercials. They generally make a good case for passive (index) investing - low expenses and superior performance. Morningstar data show that only about three of every eight funds managed to outperform their benchmarks over the last five years. The active /passive decision reduces to simple arithmetic. Or so it seems.

Passive investing by definition takes no effort on the individual investor's part, other than the selection of the index. The fund manager simply replicates the benchmark and holds the positions. No further trading, no effort to time the market and no worry about the knee-jerk responses to the nightly business, political or world news. The ease, the cost and the fact that indexes have outperformed more than half of the thousands of actively managed funds are compelling. But there are still good reasons why you might want to investigate the other group, the funds that outperform.

The investment market is huge, trillions of dollars. There are stocks of large U.S. companies, small and middle-sized companies, emerging market firms, international businesses from literally hundreds of countries, U.S. Treasury bonds, notes and bills, government agency debt, corporate debt, foreign bonds, high yield bonds, all of which have different maturities, real estate investment trusts, master limited partnerships for oil and gas transmission companies and more. And there are indexes for all of these. Choosing your index could take some study, but even if you used random selection, your portfolio construction job would not be complete. That is because the market is very diverse. These investment components do not all advance or decline equally or share equal weights in the economy. Many actually move in opposite directions.

The obvious challenge to this hurdle is that investors of all stripes can simply buy an index of the S&P 500 and another of the U.S. Treasury composite. Many studies show that this can be a competitive and generally worry-free portfolio. I don't disagree, but I think other mixes can be better, and you can take advantage of the value added with a few extra steps.

First, the list of possible investments can be intimidating. Does the inclusion of anything other than the simplest two indexes, the S&P 500 and Aggregate Bonds, really matter? The record shows that it can make a big difference. Last month the mutual fund company T Rowe Price showed the results of a study of two fund management styles covering the period from 2000 to 2013.

The period is important because it covered two bull markets and two bear markets. One style used only the S&P 500 Index (60%) and the Barclay's U.S. Aggregate Bond Index (40%). The second style was more diversified, but still used a 60/40 stock-bond mix. The diversification added both large and small cap U.S. stocks, international and emerging market stocks, U.S. investment grade bonds, high yield bonds, international developed market bonds and emerging market bonds.

The results make two important points. First, both portfolios showed reasonable compound annual growth through a very tumultuous period. It paid to be invested. The second point comes from the difference in the two funds' returns. The basic portfolio produced a 3.8% annual return. The diversified portfolio returned 5.1%. Apply those numbers to your personal portfolio. If you had $500,000 in your retirement account in 2000, the diversified style would have grown to $954,565 by January 2013. The basic approach would have ended with $811,962. Both numbers are impressive, especially given the return on cash during the same period. The diversified style was clearly superior with 46% more growth than the basic style.

We can draw at least two more conclusions from the study. Many investors would have found it difficult to generate the mix in the diversified portfolio, even using index funds or ETFs, and remember that the mix used here could have been even more representative of the asset classes mentioned in the first part of this article. That fact alone makes it easy to imagine the value of having a good investment advisor helping you with your funds.

The last, and most important point, is that through all this, many active managers did manage to outperform the averages. And if you look at the funds that outperformed in individual years, the number is far greater than the 38% that did it consistently for the entire period. As the ultimate controller of the manager selection, you have the ability to pick and choose as we go through the various market swings.

My conclusion comes in three parts: participation matters; diversification pays and active management can pay even more. There is nothing wrong with a portfolio of index funds, but more is available. Getting there is up to you.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.