MarksJarvis: Invest in index funds for better returns
Do you search the Web to find the best price on clothes or electronics? Do you drive across town to get a discount on a household item or to shave a few bucks off your groceries?
Americans love a deal. But when it comes to their 401(k)s, IRAs, or other retirement and college savings, many are lousy shoppers. Consequently, they throw thousands of dollars away buying inferior mutual funds that will fail to cover retirement or kids’ college adequately.
I’m talking about big bucks, not the $25 saved on shoes.
For years, people have been able to get the most out of their investment money by buying cheap mutual funds or exchange-traded funds (ETFs), which are called index funds. The investment industry also calls them passively managed funds because the investments in them are simply gathered together and sit month after month without tinkering.
These funds are the opposite of what are called active funds, or most of the funds sold to people by brokers or advisers who often call themselves financial consultants. Active funds sound appealing because they employ supposedly brilliant fund managers to “actively” pick winning stocks and bonds for you and steer clear of losing investments.
Who wouldn’t like such a fund? After all, no one wants a loser.
The trouble is that the brilliant activity rarely works better than picking a cheaper index fund without any brainy managers working on your behalf.
This is haunting many fund companies, which count on people buying the higher-priced “actively managed” funds.
Increasingly, investors are getting wise to the fact that they can pay less and make more money on simple index funds rather than forking over more money for the expertise of stock and bond pickers. In the last year, investors poured about $421.6 billion into simple index mutual funds and ETFs, according to Morningstar. They only put $48.9 billion into active funds. That’s a huge change from a decade ago, when passive funds were still relatively new.
Now, active funds still are managing more money than passive funds, with $10.1 trillion versus $4.5 trillion, according to Morningstar. But over the last few years, the trend to skip the active fund manager has been growing dramatically as passive funds have beat most of the pros during good times and bad times in the markets.
Whether picking stocks or bonds, passive funds have far outperformed those with active managers at the helm, said Aye Soe, senior director of research at S & P Dow Jones Indices.
Last year, as the large stocks that make up the Standard & Poor’s 500 index gave individuals about a 13.6 percent gain, the active managers who tried to beat that index flopped. Only 13.5 percent were able to do better than the index, said Soe. In 2015, only 40 percent have been able to beat the index. In other words, the extra fees individuals pay so brainy managers can make money for them are ending up being a waste.
Likewise, most stock pickers have failed to be worth their keep in funds picking small and midsize company stocks. In 2014, only 27 percent of the active small-cap stock managers were able to beat the Standard & Poor’s 600 small-cap index funds, and only 33.7 percent beat the mid-cap index, Soe found.
Advisers will argue that you can’t judge a fund based on one year, and they are correct. But Soe said most active managers have also failed in five- and 10-year periods. Even when a manager wins in a single year, he or she usually fails to keep it up for five or 10 years.
Why? It’s mostly a matter of fees. People pay more to have an active manager, and few can pick stocks and bonds that soar so much that the gains cover the fees. The average passive fund charges people about 0.2 percent to use a fund. It’s 0.79 percent for an active fund, according to Morningstar.
If a person invests $10,000 and the investments earn 7 percent annually for 20 years, the person ends up with $37,200 in the cheap passive fund and $33,000 in the more expensive actively managed fund. Try it with your funds.
Some advisers argue that active management is worth the extra money for more complicated investments like high-yield bonds, which need to be scrutinized for a potential bankruptcy. But Soe said that over the last 10 years, only 10 percent of active managers did better than the passive funds that invest in high-yield bonds.
Gail MarksJarvis is a personal finance columnist for the Chicago Tribune and author of “Saving for Retirement Without Living Like a Pauper or Winning the Lottery.”