In my book, Stock Investing for Students, I develop a long-term investment plan to achieve financial independence and an early retirement. The plan is initiated by using broad market index funds. This article will highlight the reasons why I favor passively-managed mutual funds to their actively-managed counterparts. First, some definitions.
Index fund: A type of mutual fund with a portfolio constructed to track the components of a market index like the S&P 500. It provides broad market exposure at low cost.
Actively-managed mutual fund: Active managers rely on research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell.
Statistical data resources
1- The Index Revolution
Burton G. Malkiel, Princeton
2- Common Sense on Mutual Funds
John C. Bogle, Chairman of The Vanguard Group
The case for indexing
In the long-term, it is virtually impossible for actively-managed funds to out-perform the “market” due to fees and costs. Approximately 75% of mutual funds under-perform the benchmark they are attempting to beat. To a great extent, much of this is the result of the high fees paid to fund managers and the greater rate and costs of the transactions. Index funds and index ETFs represent 30% of the market assets but only 5% of market trading.
Actively-managed funds charge fees greater than 1% while index funds average about 0.10%, more than ten times less. When computing the math regarding fees, we should calculate costs as a percentage of returns rather than total assets to get a clear picture of the damage high fees impact our net worth. Let’s assume the market returns an 8% annualized return and that actively managed funds can achieve similar results (most cannot). In doing the math, we will assume a cost of 0.10% for index funds and 1.2% for actively-managed funds. Okay, put on your seat belts:
0.10%/ 8% = 1.25% negative impact on our returns
1.2%/8% = 15% negative impact on our returns
Keep in mind that these stats assume the actively-managed funds can achieve broad market results which most cannot.
In the 4th quarter, 2016 I did a comparison of the KIP 25 (25 no-load actively-managed mutual funds recommended by Kiplinger Advisors at the end of 2015) to the Vanguard S&P 500 Index Fund. Please note that no position management was included and all positions were held for one year. Here are the results:
The Index Fund (VFIAX) out-performed the 25 actively-managed mutual funds by 4.3% (+3% compared to (-)1.3%).
Why not choose funds that have out-performed?
It is impossible to predict future results based on past performance with one very important exception. Managers that charge lower fees tend to out-perform.
- Actively-managed funds result in higher taxes causing a loss of 4% of returns over a 25-year time frame
- Indexing dramatically reduces operational costs, including transactional costs
- Indexing reduces risk via diversification
- With indexing, there are no concerns of a fund manager leaving the fund or getting ill
- Select a family of funds with low fees (Vanguard, Schwab, BlackRock as examples)
- Consider S&P 500 and Total Stock Market Index Funds
Select a high-grade diversified bond fund in a ratio appropriate for your risk-tolerance and age (stock funds in a greater percentage the younger you are)
Rebalance your index funds annually
The most important factor in the long-term success of investing with mutual funds is the cost or expense ratio. This, along with other factors, give index funds a distinct advantage over actively-managed funds.
Next live event
American Association of Individual Investors
Washington DC Chapter
Saturday July 15, 2017
9 AM – 12:00 PM
“Using Stock Options to Buy Stocks at a Discount and to Bring Portfolio Returns to Higher Levels”
Co-presenter: Dr. Eric Wish, Finance Professor, University of Maryland
Northern Virginia Community College
Richard J. Ernst Community Cultural Center
8333 Little River Turnpike
Annandale, Virginia 22003
Registration link to follow
Global stocks were flat this week, but there was significant volatility midweek as political chaos exacerbated in Washington. West Texas Intermediate crude oil rose to $50.30 a barrel from $47.50 last week amid signs OPEC and major producers such as Russia will retain output curbs through March of 2018. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), jumped as high as 15.50 at midweek before dipping back to 12.04 on Friday. The VIX began the week at 10.80. This week’s reports and international news of importance:
- President Trump embarked on his first overseas trip as president on Friday, leaving behind a litany of controversy in Washington. Trump will visit Saudi Arabia, Israel and the Vatican before a stop in Sicily for the G7 summit
- On Wednesday, the US Department of Justice appointed former FBI director Robert Mueller as special counsel to investigate Russia’s intervention in the 2016 presidential election as well as any improper contact between Russian agents and the Trump campaign
- Revelations that Trump disclosed extremely sensitive intelligence to the Russian foreign minister and ambassador during an Oval Office visit last week added to the controversy.
- UK prime minister Theresa May unveiled the Conservative Party manifesto on Thursday, setting the stage for the general election on June8th. On Brexit, the manifesto says that no deal is better than a bad one and that the United Kingdom seeks an agreement with the European Union that would take the UK out of the single market and customs union but continue close ties through a comprehensive trade and customs agreement
- The UK this week reported that its unemployment rate stands at 4.6%, its lowest level since 1975
- German chancellor Angela Merkel’s party, the Christian Democratic Union, has performed extremely well in German state elections in recent months. This potentially paves the way for Merkel to retain her post when Germany holds federal elections in late September
- Brazilian president Michel Temer, who came to office after the impeachment and removal from office of his predecessor, Dilma Rousseff, was placed under investigation by the nation’s Supreme Court this week after allegations surfaced that Temer was taped condoning the bribery of a witness in a major corruption
- After being sworn in on Sunday, French president Emmanuel Macron on Monday appointed Édouard Philippe as prime minister. Phillipe is a member of the Republicans, and his appointment is an effort to woo support from the center-right in case Macron’s En Marche! party fails to secure a majority in next month’s parliamentary elections
- Later in the week, during a meeting with European Council president Donald Tusk, Macron vowed to work for the overhaul of Europe. Tusk praised Macron, saying Europe needs his energy, imagination and courage
- Japan’s economy grew 2.2% in the first quarter of the year, its fifth straight quarter of growth, the longest string of gains in over a decade
- As of May 17th, with 458 companies in the S&P 500 Index having reported, 1st quarter earnings are expected to increase 15% from a year ago. Excluding energy, earnings are seen growing 10.7%
- Revenues growth is estimated at 7.2%, falling to 5.3% ex energy
THE WEEK AHEAD
MONDAY, May 22nd
- Chicago national activity index April
TUESDAY, MAY 23rd
- New home sales April
WEDNESDAY, MAY 24nd
- Markit manufacturing PMI May
- Markit services PMI May
- Existing home sales April
- FOMC minutes May 3
THURSDAY, MAY 25th
- Weekly jobless claims 5/20
FRIDAY, MAY 26
- Gross domestic product revision Q1
- Durable goods orders April
- Consumer sentiment May
For the week, the S&P 500 declined by 0.38% for a year-to-date return of 6.38%.
IBD: Uptrend under pressure
GMI: 3/6- Buy signal since market close of April 21, 2017
BCI: This week’s volatility and continuing political bombshells out of Washington have muted my aggressiveness moving forward. I will be taking on an equal number of in-the-money and out-of-the-money strikes for the June contracts.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a cautious outlook. In the past six months, the S&P 500 was up 8% while the VIX (12.04) moved down by 2.5%.
Wishing you the best in investing,