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THOSE OF US WHO GREW up in the 1950s watched Howdy Doody on that large, newfangled box with a picture tube and knobs. The show’s host was Buffalo Bob, who enthusiastically proclaimed Wonder Bread “helps build strong bodies eight ways.”
Subsequent nutritional research debunked that claim, and the government induced Continental Baking to add back the healthful ingredients that its processing methods were removing. The new wrapper proclaimed “enriched” Wonder Bread, even though the firm was simply replacing what had been there before.
That brings me to investing. Instead of Howdy Doody, many of us now watch CNBC, where talking heads expound on the virtues of picking stocks and making market bets. Does such active involvement help strengthen our portfolios eight ways? Consider these eight dubious contentions from fans of active management:
1. Index funds produce average—and hence unsatisfactory—returns.
Remember the game show Who Wants to Be a Millionaire? If your goal is seven figures, start making steady monthly contributions to a broad stock market index fund when you’re young. Live your life, pursue your dreams and don’t mess with your portfolio’s compounding. By the time you reach retirement age, there’s a good chance you’ll have your wish. How’s that for average?
2. Results for most index funds diverge from their underlying indexes.
Consider one of the most popular exchange-traded index funds, Vanguard Group’s S&P 500 ETF (symbol: VOO). In 2021’s soaring market, the Vanguard fund’s 28.6% total return was virtually identical to the index’s 28.7%. In last year’s tumultuous down market, the corresponding figures were -18.2% and -18.1%. What divergence are they talking about?
3. The higher cost of active funds is insignificant.
We can quickly dispense with this blatant untruth. Research has linked higher expense ratios to lower fund returns, and the longer the time horizon, the greater the impact. Suppose you invested $100,000 at a modest 4% a year—before costs. Over 20 years, you’ll end up with almost $10,000 more if you pay 0.25% in annual expenses rather than 0.5%. And, of course, most active funds charge far more than 0.5%.
4. Money managers’ massive research capability gives them a big leg up on index investing.
What leg up? It’s the outrageous cost of that research albatross that explains much of why portfolio managers consistently underperform.
5. Active funds protect investors by shifting in and out of market sectors and moving between stocks and cash.
What good is all that activity if active managers have no proven skill in the first place? On top of that, investors shouldn’t have to pay a fee for that part of a stock fund that sits in cash. We’re perfectly capable of hoarding our own cash.
6. Active managers can exploit market inefficiencies among small-cap stocks and emerging markets.
Here we can consult the last word on active vs. passive fund performance, the S&P Dow Jones Indices’ SPIVA report. In 2021’s rising market, 71% of active small-cap funds failed to beat their index bogey. Likewise, in 2021, 65% of active managers underperformed when trying to pick among emerging markets’ less followed and less liquid stocks. What about last year’s tumbling market? In the just released 2022 data, active funds succumbed 57% of the time among small stocks and 76% in emerging markets.
7. Directionless and choppy markets offer special opportunities for stock pickers.
I can’t turn up any evidence to counter or support this claim. Andrew Marchant, chief investment officer at financial advisors Minchin Moore, refers to the stock-picker story as a “nice idea that has no grounding in actual fact.” Given the inability of portfolio managers to perform well in up and down years, it seems highly unlikely they have a hidden talent for plucking promising stocks from a directionless market.
8. Actively managed funds have consistently outperformed their corresponding benchmarks.
Are they kidding me? Let’s get real by going back to that definitive SPIVA report. In 2021, just 20% of all active U.S. stock funds outpaced the S&P Composite 1500 Index. Active managers’ results “improved” to 50% in 2022, their best showing since 2013. But it’s the long-run results that are truly telling. More than 92% of U.S. stock funds have failed to beat the index over the past 20 years. Adjusted for volatility, that figure rises to an unconscionable 97%.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.
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I understand the simplicity and power of indexing. In general, indexing is a straightforward approach when faced with the daunting task of picking the best investment. However, I would posit that indexing makes most sense in taxable accounts since indexing creates less in taxable events. In tax-advantaged accounts, you are free to invest in managed or indexed investments.
With managed mutual funds, for instance, compare total returns with the benchmark index. Only pick funds that consistently exceed the benchmark index in 3/5/10 yr – shorter timeframes are noise. That will whittle down the list considerably as statistically shown in this article. Further reduce the list to eliminate funds with loads, transaction fees, and marketing fees.
When a fund loses that edge over the index, you replace the fund. If you made the initial assessment carefully, you will not be churning since you picked a consistent winner and not the latest unicorn that will revert to the mean.
Not as simplistic as invest-and-forget, but well-managed funds have a place in an investment portfolio with just a wee bit more effort in my opinion (mostly in the initial investment stage). The extra returns are worth it until simplicity rules all as you age in retirement.
As an active fund investor let’s take a look at the end process of our adventure with $. My objective was to accumulate assets and then spend those assets in retirement. Now I selected 5 funds, two of which I have invested with for decades, 3 I don’t invest with but my father did before he died. The funds are well known and large in assets. I selected the S&P 500 as the Index to compare with.
Assume we use the withdrawal method of 4% initial and increasing by 3% annually. Assume my funds and the S&P begin with $100,000 each–we begin on 01/01/2000 and we go up to the end of March 2023. We have two big bear markets and in 2020 a quick loss of 33% because of covid.
We withdraw a total of $131,127.00 during this period and the ending values, as of last month, varied from a high of $211,000 to a low of $120,180.00. The Index was worth $12,741, thus let’s bet on when it runs out money. I selected funds that invested in U.S companies so as to mimic the index . I used all the equity funds they had so as not to cherry pick.
Now, my particular fund had the highest ending value because, for 70+ years, it has invested in U.S. blue chips that pay dividends and has a standard deviation far less than the growth funds and the index. Minimizing volatility with a withdrawal program can be very beneficial.
Assume in 1970 we invested in the funds selected and the Index. All the funds beat the index even after a 3.50% load was administered so one had more $ to begin with when withdrawing for hopefully another 30-years. Seemingly I have a slim chance of running out $, unless I owned the Index.
This is not an anti-index screed just some food for thought. The first goal is to accumulate the assets–2nd goal is the distribution. Looking at past returns can help make an informed choice. For millions the index works just fine–for those like me I chose a different path.
I did retire in January of 2000 so it looks like a withdrawal program from the most popular index at that time in the equity sphere would not have worked well for me.