Kevin Michels, CFP®, EA 

Disclaimer: Index investing is only one form of passive investing, however, for purposes of this article, index investing and passive investing are used interchangeably.

Every year we do a family Fantasy Football league and regardless of each individual’s interest in football, everybody participates.  The league always starts out with a draft.  Some family members (generally those most interested in football) come prepared with a draft list after pouring over statistics and projections.  Others, (those who generally don’t care much about football), don’t give it a second thought and just let the computer auto-draft for them.

Invariably, at the end of the season, some of those family members who spent significant amounts of time picking their teams and making adjustments throughout the year end up in the bottom of the standings, while some of those who auto-drafted and spent no more than a few minutes each week putting in their line-ups, end up at the top of the standings.

In fact, we’re three weeks into the season and my mother-in-law (one of the “auto-drafters”) is leading the league with a 3-0 record, while many of the football “experts” in the family sit at the bottom of the standings with 0-3 and 1-2 records.  We see the same phenomenon play out during March Madness, where it seems like the person who spends the least amount of time or research filling out their bracket ends up winning.  Now it doesn’t always pan out this way, but you get the point.  Sometimes we make things more complicated than they need to be. 

And, so it is with investing, where giving way to your biases, making emotional decisions, trusting your instincts and spending an ample amount of time, money, and research on picking the “winners” usually results in below-than-average returns.  This is the crux of the hotly debated topic between actively or passively investing (or for purposes of this article using actively-managed funds or passively-managed funds).

Actively-managed funds spend a lot of time, effort, and money into the pursuit of outperforming a certain benchmark or index, while passively-managed funds simply aim to match the return of a certain benchmark or index.

A quick primer on indexes:  Indexes simply track the performance of different segments of the stock market.  For example, the S&P 500 Index tracks the 500 largest stocks in the United States.  When you turn on the news and hear that the S&P 500 is up 1% for the day, that means that collectively, the 500 largest stocks in the US are up 1% for the day (even though some might be up more or less than 1%).

An actively-managed fund with an objective to outperform the S&P 500 would employ a manager and a team of analysts to identify and invest in only those stocks in the S&P 500 that they believe will outperform.  A passively-managed fund or index fund will simply invest in the entire S&P 500.  There are hundreds of different indexes out there, tracking every segment and class of the stock and bond market.  Some indexes track large segments of the market such as 2000 small US companies, 900 international companies, or 8,000 investment grade bonds.  While some indexes track very specific industries such as medical stocks, energy stocks, or technology stocks.

Over time research has shown that the majority of actively-managed funds underperform their benchmark.  This is in large part due to the efficiency of the stock market and the great amount of difficulty associated with trying to pick and choose stocks that will outperform.  This is one reason why we favor index investing, however, it’s not the only reason.  In addition to better performance, index funds are lower-cost, have greater tax-efficiency, and “stay true” to the index they track.

Costs

The most attractive feature of index funds is the cost.  By cutting out the fund manager and analysts and putting the fund on auto-pilot, the fund company can offer their product at a much lower cost to investors than actively-managed funds.  The average cost of an index fund in 2017 was 0.15% compared to 0.72% for an actively-managed fund[1].  On a $100,000 investment growing at 8%, you would save roughly $11,000 in fees over 10 years, $45,000 over 20 years, and $140,000 over 30 years.  The low cost of index funds is one of the primary reasons that they usually outperform their respective actively-managed funds.

When it comes to investing, low-cost is now synonymous with index investing and that’s the biggest reason why over the past few years, billions of dollars have been flowing into passive index funds while at the same time billions have been flowing out of actively-managed funds.  In 2017 alone, a total of $692 billion flowed into index funds while $7 billion flowed out of actively-managed funds.[2]

Tax-Efficiency

Another great benefit of index funds is their tax-efficiency.  When you invest in a mutual fund, whether it be actively or passively-managed, capital gains, dividends, and interest generated within the fund are passed on to the shareholders, which becomes taxable income to the shareholder.

Since actively-managed funds buy and sell securities much more often than index funds, capital gain distributions are much higher and more frequent.  An average domestic actively-managed fund may turnover 50%-100% of their portfolio, meaning that anywhere from half to all of the securities within the fund are sold and replaced with new ones during the year (although its not uncommon for a fund to turnover more or less than that range).

Index funds on the other hand, only make trades and incur capital gains when significant changes are made to the index the fund is tracking, which is rare.  In fact, the iShares S&P 500 ETF (IVV), hasn’t had a capital gain distribution in the last 5 years.

The tax-efficiency of index funds is relevant when you invest in taxable brokerage accounts.  Unlike retirement accounts, gains from taxable brokerage accounts are taxed in the year they are realized.  By investing in index funds, you limit your capital gain distributions which allows your investments to grow without a tax drag.

Style Purity

A less talked-about, but nonetheless, great aspect of index funds is their ability to stay true to their investment objective.  There is hardly any deviation between the holdings of the index fund and the index it’s tracking.  This means that when you invest in, say, a small-cap index fund, you know that you are actually investing in the small-cap asset class.  Many actively-managed funds don’t actually stay true to their investment objective. For example, an actively managed small-cap fund has an objective of outperforming the small-cap index Russell 2000.  However, because the fund manager has discretion over what stocks to hold within the fund, he might invest not only in small-cap stocks but also in mid and large-cap stocks as well.  For example, the T. Rowe Price Small-Cap Stock Fund (OTCFX) has an objective of outperforming the small-cap index, Russell 2000.  However, if you look at the holdings in the fund, you’ll see that only 50% of the fund is invested in small-cap stocks while the other 50% is invested in mid and large-cap stocks.

This is especially frustrating if you’re trying to implement an asset allocation in your portfolio with defined percentages across various asset classes.  If your asset allocation calls for 15% of your portfolio to be invested in small-cap and you invest in the T. Rowe Price Small-Cap Stock Fund, you really only have 7.5% (15% x 50%) of your portfolio invested in small-cap stocks.

With index funds, there is hardly any deviation between the fund and the index it’s tracking, which is much more conducive to putting together a diversified portfolio.

Bottom Line

Index funds are a great low-cost and tax-efficient option to put together a diversified portfolio.  Because of their purity, you can diversify within and across many different asset classes without accidentally deviating from your prescribed asset allocation.

However, that doesn’t mean that all actively-managed funds are poor investments.  A small percentage of actively-managed funds actually do outperform their benchmarks.  If you’re considering using actively-managed funds to put together a portfolio you need to take into consideration cost, investment objective, purity, turnover, track record, management history, as well as a whole host of other factors.  And just like the actively-managed Fantasy Football team, the actively-managed portfolio may not outperform, regardless of the amount of time and research you spend choosing the right “players”.

[1] https://www.morningstar.com/lp/fund-flows-direct

[2] https://www.morningstar.com/lp/fund-flows-direct