The financial adviser on the air was telling anyone listening why he likes actively managed mutual funds and dislikes index funds.
Out came the statistics about how, since the stock market peaked, a large percentage of active funds have beaten their indexed peers. And in citing a few of his favorite funds – including a couple with alarmingly high expense ratios – he brought out the big guns.
“Index funds are much cheaper, but it’s the same in mutual funds as it is with everything else in life, and I learned from my father 30 years ago that ‘you get what you pay for.”‘
Actually, with mutual funds, one thing of which you can be certain is that you get what you don’t pay for, as the money you don’t pay in higher costs stays in your account.
Die-hard index investors will tell you that their way is right and will cite statistics to show how many fund investors fail to beat the market index. Guys like the financial planner/radio jock, selling actively managed funds, will crunch the data differently to show the benefits of having the chance to beat the market or to be protected from it when conditions get ugly.
It’s a debate that goes all the way back to the start of index funds. Consider research completed last year by Thomas McGuigan of Burns Advisory Group, a financial planning firm in Old Lyme, Conn., coupled with some data on investor returns.
McGuigan set out to determine whether active or passive management is superior – at the time he relied heavily on active managers in his own practice – and concluded that most actively managed large- and mid-cap mutual funds underperformed their benchmark passive strategies.
In each category, however, McGuigan also found that some active managers beat the benchmark but that few did so consistently. Moreover, it was “difficult, if not impossible” to predict which managers would get the job done.
It prompted McGuigan to change the way he worked with customers, moving more toward the traditional index-fund investor.
“I came to the conclusion that lower-cost, lower-turnover funds – broadly diversified global investments – were the way to go,” McGuigan says. “We can still select managers we like for one reason or another, but we lowered costs, and we improved performance.”
It’s a strategy that index fund investors live by, which is why McGuigan was concerned when he read a Morningstar Inc. report this year showing that the average investor in index funds actually captured just 79 percent of the return that he should have gained.
Indexing is designed to be a buy- and-hold strategy. While numerous studies have shown that investors in all funds tend to earn less than the fund does – because they buy in after a fund has shown big gains and sell out when a fund hits rock bottom – McGuigan was surprised to see that indexers lagged their benchmarks by so much. He figured that a rapid indexer would know better than to jump around.
His conclusion is a simple equation, one that explains the real reason many investors are better suited to actively managed funds regardless of the cost/turnover benefits of indexing:
Real investor returns equals actual investment returns plus or minus investor behavior.
“If they believe in passive investing, they need to believe it enough to stick with it,” McGuigan says. “If they believe they can pick better managers, they need to give those managers a chance.”
If you can pick a good performer, active or passive, and stick with it to get the same results that the fund actually delivers on paper, that’s when you’ll have a portfolio that has a real chance of helping you reach your financial goals.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.
