Friday, May 28, 2010

Index Funds vs. Actively Managed Mutual Funds

Index Funds can’t do everything, but I am a fan of them and have 100% of my domestic stock portfolio in index funds and about 55% of my foreign stock portfolio in index funds. I do believe there are certain individuals who can do much better than index funds. If I knew for sure who they were, I’d give them my money.

My biggest problem with actively managed stock funds are the fees they charge. Some funds charge an upfront fee for taking your money. For example, if you buy less than $50,000 of Class A shares in Putnam mutual funds, they take 5.75% off the top. In order to match an index fund, the money manager must not only beat the index fund, the manager must make up this 5.75%. But hey, Aunt Matilda left you $250,000 and if you put it all in Putnam Class A shares, they’ll drop your upfront charge to only 2.50%. (A penny less and your charge is 3.5%. So much for the little guy getting a break.) [A quick note of self-disclosure: Some years ago, I worked for a subsidiary of Marsh McLennan, which at that time owned Putnam. Other than Marsh paying me a pension every month (and so I continue to wish them well) I have no relationship with either Marsh or Putnam.]

If you can choke down the upfront costs (or find managed funds without upfront charges) there are the ongoing fees, which are also higher than an index fund. Putnam’s Equity Income Fund (a semi-random example) charged 1.16% for a recent year for the Class A shares. For Class B and C shares where there is no initial sales charge (you could suffer a deferred sales charge if you sell the mutual fund shares too soon) the annual charge increased to 1.91%.

If you dumped the whole $250,000 in Vanguard’s Index 500 Admiral Fund your annual fee is .07%. Even if you didn’t have that much money, the maximum Vanguard would charge is .18%.

Putnam’s active manager must earn the annual difference in fees just to stay even.

Oh, but it’s even worse. The Vanguard fund must buy and sell from time to time. Their portfolio turnover for 2009 was 11.5%. Putnam’s reported turnover was over 100% for the Equity Index Fund. If the manager sells stocks at a net gain, you will have to pay capital gains tax. If they sell at a net loss you do not receive any immediate tax benefit. With over 100% turnover, you will be paying taxes much sooner than with lower turnover. The sooner you pay taxes the less money you have left to earn future investment returns.

You could say that the fund you’re thinking about has a great track record. Morningstar [] gives it five stars, meaning it did great in the past. Let’s do a little thought experiment about how you to could earn the coveted five stars.

This isn’t legal, so don’t try it at home! Start with 1,032 stock picking newsletters to go along with 1,032 new mutual funds. You make only one prediction in each newsletter. On half you say the market will go up more for the year than one-year treasuries will earn, and you should buy the market. The other half you say one-year treasuries will outperform the market. Each fund follows the advice of its newsletter. At the end of the year, 516 newsletters have 100% accuracy. The other 516 were wrong and you close those funds and newsletters down. (Merge the funds into the winners so you continue to handle the money.)

Next year do the same thing: 256 pick the stock market; 256 pick treasuries and at the end of the year you have 256 newsletters and funds that have correctly picked the market of two years in a row. Quietly merge the losers into the winners.

Continue this practice. After three years you have 128 newsletters and funds left. After four years you are down to 64. Five years: 32. Six years: 16 and those are starting to get some real attention from the media. Such a simple strategy, they say, but look at the results. Remarkable – a real skill! After seven years there are still eight left. By now your eight funds are superstars and money is flocking to them. After eight years there are still four; two after nine years and after the tenth year one remains.

Time to sell the one remaining fund to Putnam or one of their competitors and retire.

Okay. That particular thought experiment isn’t legal or even very practical, but the same thing is happening each year. Some investment managers guess right; others guess wrong. Those that guess wrong too often are fired. Keep guessing right and you get more money and attention and Morningstar stars.

With way more than 1,000 investment managers out there, after ten years and solely by random luck of the dice we would expect some managers to still have unblemished success. They are dubbed investment geniuses.

Does this mean I don’t think there are true investment geniuses? No, I believe there are. But I don’t know how to tell them from the ones who have been lucky, and neither do you. That, combined with the cost advantage of index funds, leads me to prefer index funds. So why don’t I have all my foreign stock investment in index funds?

In the US we have good transparency and efficiency in the markets. That’s not the same in all foreign markets. Because of that I think foreign investment managers can add value and are worth the costs. I choose managers with a wide diversification of stocks and I cross my fingers that they can avoid some real disasters along the way.

But I still hedge my bet (and that’s what it is) and invest roughly half my foreign stock holdings through index funds.

~ Jim

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