| We couldn't agree more with Warren Buffett | | | | 3. Only talk in terms of pretax returns. With high |
| about the wisdom of using index-based funds for | | | | turnover the after-tax returns of their active |
| most institutional and individual investors. For our | | | | funds are typically much worse. |
| investors we focus on strategic asset allocation | | | | Advantages of index-based funds (relative to |
| and use index-based funds and exchange traded | | | | active funds) |
| funds (ETF's) to get exposure to each asset class. | | | | 1. Much lower costs. We build diversified portfolios |
| Most investors and advisors use "actively | | | | for our clients across multiple asset classes where |
| managed" funds where a portfolio manager | | | | the funds we use have an average expense ratio |
| attempts to beat the index by picking stocks, | | | | of only.2%-.3%. The typical active equity mutual |
| industry sectors, and timing the market. | | | | fund has an expense ratio of around 1.2%. Many |
| Unfortunately the vast majority of these actively | | | | active funds also have up-front sales loads of as |
| managed funds over time lag the index they are | | | | high as 5.75% (ouch!). |
| trying to beat, sometimes badly. Why do most | | | | 2. Lower turnover. Many active funds have high |
| investors continue to bet on them? It is the | | | | turnover ratios as the portfolio manager makes |
| triumph of hope, greed, and massive mutual fund | | | | numerous trades trying to beat the market. This |
| industry advertising over reason. It is also because | | | | results in higher transaction costs. |
| they are not aware of the poor track record of | | | | 3. More tax efficient. Index-based funds and ETF's |
| active funds relative to the indices they are trying | | | | are significantly more tax efficient that active |
| to beat. Standard and Poors updates its study | | | | funds due to their lower turnover ratios. |
| comparing the performance of active mutual | | | | 4. More transparent. You always know what you |
| funds relative to the index funds they are trying | | | | own in an index fund. With active funds you aren't |
| to beat over rolling 5-year periods. It is available | | | | sure what kinds of individual stock bets, industry |
| on their website. The financial services industry | | | | bets, or other bets they are making. |
| does not want you to see this data. The industry | | | | 5. More diversified. Index-based funds tend to |
| makes much more money on expensive actively | | | | have many more individual securities in the fund. |
| managed funds than on low-cost index funds. | | | | 6. No style drift. Active funds often drift away |
| This Standard and Poors study is a very powerful | | | | from the size/style they are supposed to use in |
| set of data in favor of index-based investing, and | | | | an attempt to chase better performance in other |
| against active funds. For domestic stocks funds | | | | areas. When you are building a portfolio based on |
| about one-third of active funds beat the index, | | | | asset allocation (like we do) you want each asset |
| among international funds less than 15% of the | | | | class to actually represent that asset class, and |
| active funds beat the index, and among several | | | | not to try to sneak into other areas in an |
| classes of bond funds less than 20% of the | | | | attempt to chase short-term performance. |
| active funds beat the index. This data is generous | | | | 7. More consistent performance. With active funds |
| to the active funds because it only shows the | | | | you have "relative performance risk" that you |
| 5-year record. Over longer periods of time even | | | | don't have to worry about with an index-based |
| fewer active funds are able to keep up with the | | | | fund. Active funds often lag several percentage |
| index. It is also being generous because this data | | | | points (or worse) behind the index when their |
| is tracking pre-tax returns. Due to their higher | | | | active bets go bad. |
| turnover active funds are much less tax efficient | | | | 8. Better performance. See the data on the |
| than index funds. The percentage of active funds | | | | Standard and Poors study. |
| that are able to beat the index on an after-tax | | | | What if I only invest in the good 5-star active |
| basis is considerably lower than shown here. | | | | funds with great performance? |
| Some people say that the large-cap U.S. markets | | | | Unfortunately past fund performance in funds is |
| are very efficient and so this data is not | | | | not predictive of future performance. Numerous |
| surprising, but that small-caps and international | | | | studies have shown this to be true. Others point |
| emerging markets are less efficient and therefore | | | | out that it would take decades to statistically |
| there is more opportunity for good active | | | | prove that a manager's good track record was |
| managers. This data refutes that as well. | | | | due to skill and not luck. Many studies have shown |
| Tricks of the Trade at the Mutual Fund | | | | that even the Morningstar famous star rating |
| Companies | | | | system fails to provide any significant predictive |
| The industry has several tricks to make it seem | | | | value for future performance. In fact a strategy |
| like their active fund performance seem better. | | | | of always buying the funds with the best recent |
| 1. Merge or close funds with poor performance. | | | | 3-5 year performance is often a horrible strategy |
| They regularly take funds with lousy records and | | | | because it ends up causing you to chase good |
| close them down or merge them into a fund with | | | | recent (past) returns, which can quickly turn in to |
| a good track record. This wipes out the bad | | | | bad performance as most strategies and styles |
| fund's track record or magically transforms it into | | | | "revert to the mean" over time. Are the portfolio |
| a good record by merging it. This creates what is | | | | manager(s) on the fund still the exact same now |
| called "survivorship bias" in the numbers. The | | | | as when the past track record was created? Is |
| Standard and Poors data above corrects for this | | | | the fund still the same size as it was when the |
| bias. | | | | track record was created (it's much more difficult |
| 2. Advertise only the funds with good recent | | | | with a larger fund)? The single best predictor of |
| performance. It seems like all you ever hear | | | | future performance is the fund's expense ratio |
| about is the great funds all these companies have, | | | | (lower is better). |
| since those are the only ones they talk about. | | | | |