THE RATIONAL INVESTOR: Mutual fund investors should focus on broad-based index funds

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Another year, another disappointing year, for actively managed mutual funds versus index-tracking mutual funds. I regularly try to convince readers interested in mutual funds that the rational decision is to eschew actively managed funds; however, some are seduced by the “promise” of market beating performance, even though the data show it’s elusive. That doesn’t mean there isn’t some “needle in the haystack” active fund that will occasionally beat the market in a given year; however, investing in equities is by its very nature a long-term endeavor and index mutual funds in essentially all asset classes have shown themselves able to produce long-term returns superior to actively managed funds.

Every year the evidence becomes more overwhelming that a portfolio of low-cost index funds that investors manage themselves is a sound strategy. It’s straightforward to construct such a portfolio; there’s no reason to look at actively managed funds or pay a financial adviser to manage that portfolio.

One reason to avoid them is most actively managed funds don’t survive long-term. According to Standard & Poor’s, “Over 20 years, nearly 70% of domestic equity funds and two-thirds of internationally focused equity funds across segments were confined to the history books.” Funds that disappear generally do so because of inferior performance.

This doesn’t happen to broad-based index funds.

Recall, an index fund seeks to match the performance of some generally recognized index, for example, the S&P 500. An actively managed fund tries to outperform the market or some segment of it. Thus, it risks underperformance and sometimes drastic underperformance, often caused by too rapid growth. Unlike actively managed funds, significant growth in index funds doesn’t detract from their performance because they just invest more money in the index, and these are so diversified it doesn’t cause problems. Since their performance tracks the index, they don’t go out of business because of inferior performance.

Another reason to select index funds is that their longer-term performance is almost always better than actively managed funds.

For example, according to the Standard & Poor’s SPIVA report through 2021, 85% of managed large-capitalization funds underperformed the S&P 500 in 2021, making it the 12th consecutive year that a majority underperformed. Also, it’s notable that 79.6% of all domestic equity funds underperformed the S&P Composite 1500 in 2021. According to S&P, “Among domestic equity funds, while 90% have underperformed the S&P Composite 1500 over the past 20 years, an even greater 95% did so on a risk-adjusted basis.” Results for actively managed funds were, in general, worse the longer the timeframe considered.

Non-U.S. funds followed the same pattern: the longer the time frame, the higher the percentage of actively managed stock funds that underperformed their appropriate index. For example, about 85%-90% of international focused stock funds underperformed their index over the last 20 years.

In general, U.S. fixed-income funds followed the same time frame pattern.

It’s not impossible to find an actively managed fund that will outperform, but it’s difficult. Selecting a currently top-quartile one doesn’t solve the problem, as studies show few will stay there even for three years.

All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at rsstepl@tampabay.rr.com. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.

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