Mutual Funds

LOOKING TO BUY FUNDS to build your desired portfolio? You’ll be immediately confronted with a crucial choice: Should you buy actively managed funds, market-tracking index funds or some combination of the two?

Most funds are actively managed, meaning they try to pick securities that’ll outpace some market index. This has proven tough to do, with a high percentage of active funds generating market-lagging results.

For proof, check out the regularly updated study from S&P Dow Jones Indices, part of S&P Global. The so-called SPIVA study (short for Standard & Poor’s Indices Versus Active) compares the performance of actively managed stock and bond funds to appropriate benchmark indexes. The results are not encouraging for actively managed funds.

Over 20 years, the vast majority of active funds in the various U.S. style boxes underperform their benchmark index, with the failure rate typically running at more than 90%. The failure rate among bond and foreign-stock fund is also high, with a majority of funds in each category failing to beat their benchmark index. The full data can be found here.

Why have actively managed funds struggled? You can blame it on two issues: the cost of active management and the efficiency of the financial markets. We take a closer look at investment costs in the sections that follow, including the cost of using a financial advisor. Later in this chapter, we turn to the issue of market efficiency.

The poor performance of actively managed funds has driven many investors to dump active funds and instead buy index funds, which simply seek to replicate the performance of a benchmark index. In recent decades, index funds have been easily the fastest growing area of the fund management business.

Next: Why Costs Matter

Previous: Step 4: Investments

Article: Top of the Class