Part 5: Managed vs. Index Mutual Funds
By Patrick Rau, CFA ∙ May 2016
The difference between managed and index mutual funds is pretty straightforward. Managed mutual funds try to beat the performance of the overall market, as measured by a benchmark index. For example, a U.S. large-cap managed mutual fund may try to beat the return of the Russell 1000 Index, which is a measure of 1000 of the largest publicly traded U.S. companies. Meanwhile, a U.S. large-cap index fund may simply try to replicate the performance of the Russell 1000 Index, by investing in the same amount and proportion of stocks that comprise that index.
Investment sites abound with the disclaimer that past performance is not a guarantee of future investment success. The same can be said about judging managed mutual funds solely on their past performance. Fund managers may be able to keep churning out market beating returns for several years at a time, but there are numerous academic studies that show that managed funds have difficulty beating their benchmark averages over the long-run.
In his book A Random Walk Down Wall Street, Burton Malkiel offers some pretty compelling evidence. He notes that from 1970-2009, out of the 358 equity funds that could be benchmarked against the S&P 500 Index, only 119 were still operating. Of these 119, only 44 matched or outperformed the S&P 500, a mere 37%, and only 5 by more than 2%. But the record would be far worse if one included the 239 funds that were excluded from this sample because they were shuttered by managers for being unsuccessful. If you ignore this “survivorship bias” and include all 358 funds, then only 12% of them met or beat the index.
Author Charles Ellis noted in his 2014 Financial Analysts Journal article entitled The Rise and Fall of Performance Investing that in 2012, Eugene Fama, who is another pretty big hitter in the financial world, summarized his study of the performance of all domestic mutual funds with at least 10 years of results this way: “Active management in aggregate is a zero sum game before costs…After costs, only 3% of managers produce a return that indicates that they have sufficient skill to just cover their costs, which means that going forward, and despite extraordinary past returns, even the top performers are only expected to be about as good as a low-cost passive index fund. The other 97% are expected to do worse.”
So why the long-term underperformance of managed funds, especially from financial professionals who have been trained in the intricacies of security analysis and portfolio theory, and who have the time and resources to find mispriced securities? There are several important reasons, many of which are simply out of the control of fund managers:
1.) Fees and expenses – This is often the biggest culprit, and I work through mathematical examples of just how much fees can hurt investment returns in the next article, entitled Should I Hire an Investment Professional? For now, just know that the negative impact can be significant, especially over the long-run. Managed mutual funds have higher expenses than their index fund counterparts because managed funds are trying to beat the index. That means they must hire portfolio managers, investment analysts, and spend money on research materials. Index fund managers simply replicate an existing index, and there are far fewer expenses required to do that. For example, in 2014, U.S. managed equity funds had a median expense ratio of 1.25% (125 basis points), close to a full percentage point more than the 0.44% for equity index funds.
As William Sharpe (yes, he of the Sharpe Ratio from Part 1 of this series) wrote in his 2013 Financial Analysts Journal article entitled The Arithmetic of Investment Expenses, “under plausible conditions, a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments.” Furthermore, that number could be even higher after accounting for transaction costs, the drag that cash holdings have on investment returns, and sales charges. John Bogle, the founder of index funds, estimates that Sharpe’s 20% estimate could be more like 65% after incorporating these other “hidden fees.” He is biased, of course, but he does make a valid point. Including these other fees that are not typically incurred by index funds, or at least not to the same degree, will likely increase the longer term performance of index funds over managed funds, everything else being equal.
About the Author
Patrick Rau, CFA, is a former Wall Street equity research analyst on both the sell and buy sides. He has covered a number of industries over the years, including specializing in the oil & gas and semiconductor sectors, and serving as a generalist. For examples of his previous stock picks, please see the Equity Research tab. Pat is married to Brenda Rau, Licensed Real Estate Salesperson with Compass Real Estate in NYC.
Other Articles in this Series
Part 1 - Historical Asset Class Returns
Part 2 - Modern Portfolio Theory in Five Minutes
Part 3 - The Asset Allocation Process
Part 4 - Mutual Funds vs. ETFs
Part 6 - Should I Hire An Investment Professional?
Part 7 - Things That May Improve Your Portfolio's Performance
Part 8 - Thoughts on Retirement Spending
Part 9 - Diagnostic Portfolio Checklist
2.) Turnover - More active funds have a higher turnover rate, which increases the commissions they pay, leading to increased expenses, everything else being equal.
3.) Bad decisions – Some managers are simply better than others, and even the best managers aren’t always right. Sometimes, investment ideas that look like a slam dunk don’t always work out. How many people foresaw #15 seeded Middle Tennessee beating #2 seeded Michigan State in the first round of the 2016 NCAA Men’s Basketball Tournament? Diversification helps limit the negative impact of unexpected outcomes like this, but bad decisions and at times just plain bad luck can cause performance to lag the overall market.
4.) Poor risk control – A lack of proper internal risk controls can cause a portfolio manager to become over-weighted in industries that may underperform the overall market, and/or take on investments that are riskier than the limits established by the fund’s investment policy.
5.) Position limits set by the fund – This is typically done in the name of diversification, and as I explained in Part 2 of this series, diversification has a number of benefits. Many managed funds have self-imposed limits in place that prevent them from owning more than say 5%-10% of the outstanding stock of a particular company, or having that company comprise more than a certain percentage of their total investment portfolio. However, this may prevent a fund manager from investing in as much of that security as he or she would like.
6.) Being forced to sell securities that no longer meet the fund’s investment objective – I have a good friend who is an analyst for a U.S. mid-cap fund who complains about this all the time. Sometimes, their best picks do so well that these stocks grow from being mid-cap to large-cap names. Once that happens, their managers are forced to sell those stocks, even if they believe these companies remain undervalued.
7.) Fund becomes too large – This is an all too familiar problem with funds that have a short-term track record of beating their particular index. Investors see the excess returns, and increase their contributions, which means the portfolio manager has to invest those funds in something, since they aren’t being paid to hold cash - you don’t need to hire someone to do that, since you can just leave your money in the bank. Because of position limits, this could mean investing in suboptimal securities, or in so many different stocks and sectors that the fund begins to replicate the very index it is trying to outperform.
8.) Manager turnover – Good managers get hired away or retire, leaving the fund with someone who may not be as proven or talented.
9.) More sophisticated traders and trading techniques - The increased number of trained financial analysts and supercomputer driven trading algorithm programs have helped eliminate market inefficiencies, which makes it all the more difficult for any one fund to capitalize on those.
10.) Increased reguatory oversight - In August 2000, the U.S. Securities & Exchange Commission passed its Regulation Fair Disclosure (Reg FD) that required companies to disclose material information to all investors at the same time. Prior to that, companies oftentimes revealed information to institutional investors before releasing it to the general public.
The two best indicators for predicting the future long-term performance of mutual funds are likely expense ratios and turnover, and several prominent studies suggest the same. This insinuates that low cost index funds are probably ideal for most investors. The aforementioned data suggest index funds beat managed funds as much as 97% of the time in the long-run. Other studies show that high flying performers one year fail to beat the market in subsequent years. However, there are a number of managed funds that do beat the market more often than not in the shorter-term, which I believe is largely the result of management performance. Such performance is difficult to repeat over the long-haul, for all the reasons I have mentioned, but shorter term success is certainly possible. Plus, even though index funds beat most managed funds over the long-run, they will never actually beat the market itself, either in the long or short-runs.
For the record, it isn’t as though active portfolio managers do not have any value, or fail to offer any societal benefits. They help make the market more efficient and more liquid, and therefore more investable. Analysts and portfolio managers at least indirectly scrutinize company managers, which could make them more effective, and that in turn may make investments in those companies more lucrative. These are all good things. Many portfolio managers are able to post market beating returns more often than not for several years running, but this becomes much more difficult to accomplish for periods of ten years or more. All too often, excellent fund managers become victims of their own success.
If you do wish to attempt to beat the market by investing in managed funds, perhaps the following screening criteria will help. No guarantees, of course, but this is a far more disciplined approach than simply investing in the “hot” fund.
My Screening Criteria For Selecting Index Funds & ETFs
This is much simpler, and there are fewer things to look for, because these funds simply replicate an underlying index.
1.) No or low sales load – The less you pay in upfront commissions, the more your money goes to work for you.
2.) Low expense ratio – By now, this one should be obvious. But several studies suggest there is an inverse relationship between expense ratios and returns. The lower the ratio, the higher the returns, everything else being equal.
3.) Past Performance – Past performance tends to be less a predictor of future success than expense ratios, and, of course, there’s the standard caveat that “past performance is no guarantee of future success.” However, I do like to look at past performance when comparing index funds, because some indexes are constructed a bit differently from others. For example, one large stock index may be weighted by the market capitalization of its member stocks, while others may be equally weighted. This will likely have an impact on how indexes may perform relative to each other. More on this below.
Smart Beta Strategies
One of the newest developments in the ETF world is the concept of “smart beta,” which involves reconfiguring the weights of an existing market index in an attempt to better its return. For example, the S&P 500 Index is weighted by market capitalization, so the largest companies comprise a greater share of the index. The Guggenheim S&P 500 Equal Weight ETF (Ticker: RSP), on the other hand, treats each of the 500 companies in the S&P 500 index equally. By doing that, this ETF automatically puts more money into the smaller companies, which may in fact be undervalued. Smart betas funds alter the weights of established indexes by fundamental factors such as P/E ratios, or other criteria, like dividend yields, company size, quality, momentum, and low volatility.
Smart beta strategies are still considered to be passive, since they follow a pre-determined formula, as is the practice of regular index funds. However, the smart beta approach carries an element of active management as well, since the goal is to beat a particular index, rather than to simply match it. Because they do require some periodic portfolio rebalancing, smart beta ETFs tend to have higher expense ratios than index funds, but lower than those for traditional actively managed funds.
According to Morningstar, as of June 2014, there were 367 smart beta exchange traded products in the United States, and several sources pegged total smart beta assets under management in the $400 billion neighborhood in 2015. Most smart beta funds are equity focused, but fixed income smart beta products may soon emerge.
I expect smart beta ETFs will continue to grow, particularly those that have more of a value focus, such as those with equal, fundamental, and dividend yield weights. Research has long shown that value investments tend to outperform growth focused ones over the long-term, which gives these ETFs with a value tilt something of an advantage. Actively managed funds have a tough row to hoe when it comes to beating index funds over time, but the combination of a value tilt and low expense ratios may very well give these value focused smart beta ETFs a fighting chance to beat their respective indexes over the long-run. Several prominent studies within the last few years suggest the same. As a result, it may make sense for investors to hold at least a small portion of their investments in these securities.
Next Time
Another potential option for beating the market is to hire an investment professional to manage part or all of your portfolio for you. But as I explain in the next article, the decision to do so requires a cost/benefit analysis, both in terms of actual dollars and lifestyle choices .
Patrick Rau, CFA, is a former equity research analyst, both on the sell-side specializing in energy and the buy-side as a generalist for a financial advisory firm. He holds a B.A. in Economics from the College of William & Mary, and an MBA in Finance from Georgetown University. He is married to Brenda Rau, Licensed Real Estate Salesperson with Compass Real Estate in New York City.
Disclaimer: All information and calculations are based on information deemed to be reliable. Patrick Rau, CFA is not an investment advisor, and this paper is for educational purposes only. Nothing herein should be considered financial or investment advice. Moreover, Patrick Rau, CFA shall not be held liable for any losses or damages that may result from any decisions you make based on any of this content.