Fact: Index fund investors tend to do better than investors in actively managed mutual funds.
Is this because most mutual fund managers can't seem to get their acts together and beat the indexes? That's part of it. Is it because of the sometimes staggering fee differential between actively managed funds and passively managed index funds? That's definitely a big factor.
But the bottom line is that it doesn't much matter what kinds of after-fee returns actively managed funds are able to produce -- the sad fact is that most investors in those funds typically end up with significantly worse returns than what the fund actually generates. A 2007 study by Zero Alpha Group (ZAG) showed that, on average, index fund investors tend to lag the returns of their funds by 0.47% per year, while investors in actively managed funds lag by a whopping 1.7%.
While 1.7% may not sound like a lot, consider this: Over the course of 30 years, $250,000 turns into $4.36 million with 10% returns, but it reaches only $2.73 million with 8.3% returns.
Does $1.6 million strike you as something worth paying attention to?
ZAG's study is hardly some wonky view that may or may not hold water. The tendency for mutual fund investors to underperform the funds they invest in is no big secret. The knowledge of this is so strong that it spawned a myth that half of the investors in Fidelity's Magellan Fund during Peter Lynch's tenure -- which produced 29% average annual returns -- actually lost money.
Though the Lynch/Magellan story may be apocryphal, the lesson from the real studies that have looked at this tendency is something that every investor needs to brand their gray matter with.
In simple terms, mutual fund investors underperform their funds because they are terrible at timing the market. They buy during ebullient times when everything's frothy and then have a tendency to sell when panic is in the air and blood is running in the streets. Buy high and sell low is always a recipe for disappointment.
But why doesn't this happen to index fund investors to the same extent? It's because, for the most part, they don't bother trying to time the market. By investing in index funds in the first place, this set of investors has basically said, "I give up, I'm just going to take the market's returns and call it a day." So it's not all that surprising that they don't bother hopping in and out of their investments.
Indexes aren't perfect
Though I do not subscribe to the efficient markets theory -- which is often used as a reason to invest in index funds -- I do think that index funds can be a great vehicle for many investors. In fact, when it comes to emerging-market exposure, I prefer to use an index fund myself because, though I see the opportunity in those markets, I don't feel like I can get enough insight into the companies to invest in them individually.
However, there are drawbacks to investing in indexes. For one, most of the major ones weight the holdings based on size, so the bigger a company gets -- regardless of whether that comes from profit growth or a runaway valuation -- the more of it the index will own.
An example of how this can get out of hand is the recent Nasdaq 100 rebalance. Prior to the rebalance, Apple (Nasdaq: AAPL ) accounted for more than 20% of the index. Investors thinking that a 100-stock index would give them good diversification likely had no idea how much their investment was set to live and die on the fortunes of one company.
In addition, by their nature, indexes invest in everything within certain bounds. So if I buy an S&P 500 index fund, I'm getting shares of Southwest even though as a rule I don't invest in airlines (even though Southwest may be the best of the bunch). In addition, I'll end up with shares of Netflix (Nasdaq: NFLX ) , even though I think that the near-50 forward price-to-earnings multiple means that low returns are ahead (though my fellow Fools at Motley Fool Stock Advisor disagree).
That's why, when it comes to investing in U.S. and multinational companies, I prefer to pick out individual stocks that have more attractive characteristics -- lower valuation, higher dividends, better business -- than the average index fund holding.
Patience: Not just for index funds
I recently wrote an article "5 Stocks for the Next Three Decades." It wasn't meant to simply be a clever, eye-catching title. My intent was for readers to really think about what it would mean to own a stock for 30 years.
Think that sounds crazy? Many large, well-known companies have produced very impressive dividend-adjusted returns over the past 30 years. ExxonMobil (NYSE: XOM ) returned 14% per year, General Electric (NYSE: GE ) delivered 12.6% per year, and Merck (NYSE: MRK ) managed 12.9% per year.
Of course it's been anything but a straight line for these stocks over the three-decade span, and there were plenty of opportunities for investors to buy high, sell low, and shoot themselves in the foot.
But what if we approached investing in individual companies the way index fund investors view their investments? Granted, when it comes to individual companies you can't ignore significant changes in the business that make it unattractive. But what happens when you shut out the Wall Street and media circus and hang onto a high-quality stock for years and years, if not decades?
As is usually the case, we could do worse than using Warren Buffett as an example. Twenty years ago, Coca-Cola, Gillette (now owned by Procter & Gamble), GEICO (now fully owned by Berkshire Hathaway (NYSE: BRK-B ) ), The Washington Post Co., and Wells Fargo (NYSE: WFC ) were five of Berkshire Hathaway's seven largest holdings. Buffett has seen fit to continue owning a significant stake in all of these companies.
Of course, it all seems too simple right? With all of the thick books and countless hours of TV coverage of experts opining on the ins and outs of investing, could it be that patience is really the missing ingredient for most investors? Head down to the comment section and let me know what you think.
Looking for companies worth owning for the really long run? The free special report "13 High-Yielding Stocks to Buy Today" is a great place to start.