Mutual Fund Madness: A Simple (and Successful) Investment Strategy

It is widely accepted that individual investors should diversify their assets so that they aren’t too prone to a downturn in one sector. For those investors, it’s hard to beat the diversification of mutual funds: Instead of individually buying up and monitoring stock in a bunch of companies to ensure that their portfolio is balanced, investors get to pool their money with others and buy into a fund that does those processes for them. Sounds simple enough, right?

Well, not quite. In trying to decide the “Best Mutual Funds for 2010,” US News and World Report assigned scores to over 4,500 different mutual funds. My Charles Schwab account (which I love, by the way—their service made it incredibly simple to start investing) lists over 9,000 matches for a broad search of mutual funds. There are a lot of options to sort through.

With all of those choices, how could a young adult, busy with school or a job, possibly comb through them all and make the best decision?
Thankfully, you don’t have to comb through all of them; there’s a choice that is both simple and highly effective. That choice is investing in what are called low-cost index funds.

Whereas most mutual funds are actively managed—that is, they have fund managers who research specific stocks, react to market trends, and do other similar things—index funds are, by definition, passively traded. Instead of micro-managing their holdings and assets, these funds attempt to replicate a certain market—for example, the S&P 500—and just grow with the market. And get this: these index funds regularly outperform actively managed funds.

It might be hard to believe that a hands-off, ‘uninformed’ investment strategy could beat the supposed wealth gurus of Wall Street, but it happens very consistently. It happens so frequently, in fact, that behavioral economists—academics who analyze the psychology and behavior of stock-traders—overwhelmingly recommend index funds as an investment strategy. (The book Why Smart People Make Big Money Mistakes and How to Correct Them is a great example of such advice.)

Here are just two of the reasons why index funds regularly beat actively managed funds:

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1. 

Index funds have far lower fees. Actively managed funds have much higher overhead costs than index funds and thus use more of your investment to cover those costs, rather than simply investing the money.

For example, the funds have to pay high salaries to the managers, purchase research resources, have the office space and equipment to conduct trades, plus a variety of other services. Index funds, on the other hand, are quite minimalistic: there are rarely lavish manager salaries or research purchases because the fund is dictated largely by the market. Thus, index funds’ net expense ratios—the percentage of your investment that goes toward covering costs—are typically far, far lower.

Don’t think that fees matter if you’re getting ‘expert’ guidance on your investment? Well, think again. Over the past 23 years, active funds have trailed the benchmarks they’ve attempted to beat by an average of one percentage point. In other words, the ‘expert’ funds that attempt to beat the market’s general performance have routinely lagged that performance. Index funds, on the other hand, routinely match the market’s performance (and outperform active funds) because that is their purpose and they have few fees to get in the way.

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Still not convinced? Here’s an example that illustrates how even relatively average fees can erode your investment over time, compared with a low-cost index fund:

If you invest $1,000 at the start of every year without any fees, after 40 years your investment would be worth about $213,000—a pretty tidy sum. If your fund has a net expense ratio of 1.25%, however, you would be losing $12.50 out of each $1,000, plus your money would be compounding less quickly. The effect? After 40 years, your money is worth only $153,000. And keep in mind that 1.25% is below the average expense ratio for an active fund.

A typical index fund has far lower fee structures, so you keep more of your investment. My initial S&P500 index fund with Schwab was down at 0.09%, so there’s plenty of room to scrimp. And as I mentioned above, it isn’t really scrimping, because you’re likely to outperform those expensive funds anyway.

2. Active trading is largely random. Although it can be very tempting to invest in the hot new funds that magazines are touting, it is important to remember that short-term performance of a fund is no guarantee of future performance. In other words, just because a fund has had a very solid three years does not mean that it will have a solid fourth.

Here is some evidence that success in actively managed funds is largely random: A paper by Eugene Fama and Kenneth French—faculty at the University of Chicago and Dartmouth Business Schools, respectively—created a series of artificial mutual funds by running a program that randomly selected stocks to purchase and trade. The result? When the average performance of these randomized mutual funds were compared with the performance of actual mutual funds, the figures were nearly identical.

Of course, even in the Fama and French example, a few active managers did happen to outperform the randomized funds. The issue for individual investors, however, is determining whether that happened because of luck or skill. If it is skill, then the trouble for investors is identifying that skill before the manager beats the market, not after they have and thus boost their fees or jump to a higher-paying fund. Even if there are skilled fund managers out there, it is incredibly difficult for a normal investor to identify them, and investors will pay quite a premium for choosing incorrectly (as discussed above in the fees section). Most investors will get far better returns from index funds.

What’s the takeaway of this post? Most investors, particularly young people with limited knowledge of the stock market, should invest in low-cost index funds and let their money grow with the market. It is incredibly difficult, if even possible, to predict which higher-cost funds will manage to beat the market in a given year. And even when those funds do beat the market, a large amount fail to in the next year. Flipping a coin will eventually yield ten heads in a row, particularly when there are thousands of coin-flippers participating. You are far better off putting your money with the market than you are in taking a loser’s gamble.

And if you need one last reason to invest in index funds? Even Warren Buffett thinks that most people should just put their money in index funds. Enough said.

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Photo from above is available here.