Question

Based upon the evidence and the textbook, discuss the long-term performance of actively managed mutual funds relative to the Standard and Poor’s 500. What are your thoughts on this evidence? Provide real world example

Answer 1

Index Funds vs. Actively Managed Funds

Investing in an index fund is a form of passive investing. The opposite strategy is active investing, as realized in actively managed mutual funds—the ones with the securities-picking, market-timing portfolio manager described above.

1.Lower Costs

One primary advantage that index funds have over their actively managed counterparts is the lower management expense ratio. A fund's expense ratio—also known as the management expense ratio—includes all of the operating expenses such as the payment to advisors and managers, transaction fees, taxes, and accounting fees.

Since the index fund managers are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others that assist in the stock-selection process. Managers of index funds trade holdings less often, incurring fewer transaction fees and commissions. In contrast, actively managed funds have larger staffs and conduct more transactions, driving up the cost of doing business.

The extra costs of fund management are reflected in the fund's expense ratio and get passed on to investors. As a result, cheap index funds often cost less than a percent—0.2%-0.5% is typical, with some firms offering even lower expense ratios of 0.05% or less—compared to the much higher fees actively managed funds command, typically 1% to 2.5%.

Expense ratios directly impact the overall performance of a fund. Actively managed funds, with their often-higher expense ratios, are automatically at a disadvantage to index funds, and struggle to keep up with their benchmarks in terms of overall return.

If you have an online brokerage account, check its mutual fund or ETF screener to see which index funds are available to you.

Pros

• Ultimate in diversification

• Low expense ratios

• Strong long-term returns

• Ideal for passive, buy-and-hold investors

Cons

• Vulnerable to market swings, crashes

• Lack of flexibility

• No human element

• Limited gains

2.Better Returns?

Lowered expense leads to better performance. Advocates argue that passive funds have been successful in outperforming most actively managed mutual funds. It is true that a majority of mutual funds fail to beat broad indexes. For example, during the five years ending December 2019, 80% of large-cap funds generated a return less than the S&P 500, according to SPIVA Scorecard data from S&P Dow Jones Indices.1

On the other hand, passively managed funds do not attempt to beat the market. Their strategy instead seeks to match the overall risk and return of the market—on the theory that the market always wins.

Passive management leading to positive performance tends to be true over the long term. With shorter timespans, active mutual funds do better. The SPIVA Scorecard indicates that in a span of one year, only 70% of large-cap mutual funds underperformed the S&P 500. In other words, over one-third of them beat it in the short term. Also, in other categories, actively managed money rules. As an example, nearly 70% of mid-cap mutual funds beat their S&P MidCap 400 Growth Index benchmark, in the course of a year.2

Even over the long term, when an actively managed fund is good, it is very, very good. Investor's Business Daily's "Best Mutual Funds 2019" report lists dozens of funds that have racked up a 10-year average total return of 15% to 19%, compared to the S&P 500's 13.12%. They've significantly outperformed the market in one-, three-, and five-year periods, too. Admittedly, this a feat that only 13% of the 8,000 mutual funds out there can claim, as detailed in the report.

Real World Example of Index Funds

Index funds have been around since the 1970s. The popularity of passive investing, the appeal of low fees, and a long-running bull market have combined to send them soaring in the 2010s. For 2018, according to Morningstar Research, investors poured more than US$458 billion into index funds across all asset classes. For the same period, actively managed funds experienced $301 billion in outflows.3

The one fund that started it all, founded by Vanguard chairman John Bogle in 1976, remains one of the best for its overall long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. It posts a one-year return of 7.37%, vs. the index's 7.51%, as of July 2020, for example. For its Admiral Shares, the expense ratio is 0.04%, and its minimum investment is $3,000.