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 will 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 active funds, with most funds trailing behind the market.
For instance, over the 20 years through December 2020, the vast majority of funds in the nine U.S. style boxes underperformed their benchmark index. The failure rate ranged from 76% for small-cap value funds to 96% for both large-cap growth and large-cap blended style funds. Meanwhile, among international funds, the 20-year failure rate varied from 87% for global funds (which own both U.S. and foreign stocks) to 92% for emerging markets funds. The 15-year results for bond funds were almost as disheartening, with the failure rate running at 71% or higher in all but two categories. Even the most-promising category saw 63% of actively managed bond funds lag 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