If you invest in stock mutual funds that actively manage their portfolios, you're probably paying the price for that active management in the form of higher fund expenses and costs. Each and every year, you pay a portion of your investment to cover these expenses. By doing so, you hope that your fund will benefit from its active management, giving you better returns and compensating you for the extra money you're paying to your fund. So as the years go by and your investments continue to grow, the question you have to ask yourself is this: Are you getting your money's worth?
The ongoing battle
Ever since Vanguard founder John Bogle introduced his First Index Investment Trust, the forerunner of what would eventually become the Vanguard 500 Index Fund (VFINX), a debate has raged between those who believe active management is the best way to earn exceptional market returns and those who argue that low-cost passive investing techniques are the best bet over the long run. Both camps have had periods of success and failure, as some market environments seem to favor actively managed funds, while others tend to handicap active management in comparison to index funds.
The latest battle appears to be going to supporters of index funds. A Standard & Poor's study cited by The New York Times finds that relatively few actively managed mutual funds are outperforming the S&P 500 index. So far in 2006, less than one fund in three has outperformed the benchmark index. When you look only at the third quarter, the results are even more clear, with only 20% of funds doing better than the index.
Over the short term, investment performance is not a terribly good indicator of a fund's long-term performance. Even the best funds will have bad quarters and years from time to time. However, the study also found that even over longer periods of time, actively managed funds have had a tough time matching the performance of index funds. Over the past five years, less than one mid-cap fund in five outperformed the S&P 400 index of mid-cap stocks, and less than one small-cap fund in six beat the S&P 600 index of small-cap stocks. Large-cap funds did a bit better, but still fewer than 30% of them had higher returns than the S&P 500.
Paying for nothing?
Certainly, that kind of underperformance isn't what you expect when you pay for a manager to run your mutual fund. You want someone who will correctly identify when technology stocks like Intel
Yet the evidence clearly supports the proposition that you can't count on getting your money's worth from active fund management. Many managers choose not to invest all of a fund's money in stocks, which can reduce returns when stocks are rising. Some funds engage in transactions designed to make them look good for their annual reports. These so-called "window dressing" transactions may succeed in getting popular names onto a fund's list of holdings, but they don't earn any profits for the fund's shareholders. There are a host of reasons why many managers can't match the performance of a passive index, but many of them have little to do with giving fund shareholders any benefit from the actions of those managers.
Money in your pocket
Even though fund managers may add little or no value, the fees they collect aren't just chump change. With nearly $10 trillion in mutual fund assets as of September 2006, fees for active management raise tens of billions of dollars each and every year for mutual fund managers. There's certainly plenty of money motivating active managers to find ways to convince investors that they're worth their fees.
From the standpoint of the individual investor, mutual fund fees often go unnoticed. However, they're extremely significant and represent a large handicap for savers to overcome in trying to reach their financial goals. For someone seeking to accumulate $1 million over a period of 30 years, a 1% fee for active management of your mutual fund portfolio can easily cost you $100,000 or more before you reach your target. In contrast, index funds, which have much lower expenses and other costs, can charge as little as a tenth of that. It's like going to a 90%-off clearance sale. You can get the investments you need without paying top dollar for a brand name that doesn't necessarily offer higher quality.
Index funds are just another example of how the exciting choice isn't necessarily the best choice when it comes to investing. Actively managed funds hold out the promise of highly trained professional investors who can use their prowess to give you returns that will let you achieve your dreams quickly without the need for patience and discipline. Investing in an index fund, on the other hand, seems like giving up. It's an admission that you don't think you can do any better than average in choosing stocks. Yet over time, index funds may well leave you with more money in your pocket.
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Fool contributor Dan Caplinger likes index funds for their simplicity and efficiency. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy always gives you good performance.