Every day we're faced with choices -- PC or Mac? Pepsi or Coke? Boxers or Briefs? Kobe or Lebron? Active or Passive [mutual fund management]? Ok, so most of our daily decisions are not life or death, but many decisions will have a direct bearing on our overall financial well-being.
Active vs. Passive (Index) Fund Management.
Accompanying a typical [active] mutual fund are high costs/ maintenance fees (i.e., expense ratio). Why? You're paying a fund manager to select the investments (stocks, bonds, etc.) that will comprise the fund. Is it worth it? Ultimately, only you can decide the answer to that. In the final analysis, you will need to determine if the higher fund costs are yielding higher fund returns ...
According to Morningstar Principia, a database of over 15,000 mutual funds, the median annual fund expense was 1.42%. (In addition, more than 10,000 of these funds also levy a sales charge or "load" - a topic for another day ...)
- 42% of funds had expenses over 1.5%
- 52% of funds had expenses between .5% and 1.5%
- 6% of funds had expenses less than .5%
The most common example of passive fund management is an index fund. A fund designed to track the activity/return of its underlying index (i.e., S&P 500, Nasdaq, Dow, etc.). The S&P 500, a broad market index of 500 of the largest companies in the U.S., is one of the most common types of index funds. Since the listing of those 500 companies is readily available (not stocks that would need to be 'handpicked' like an actively managed fund), you can typically purchase this type of passive management at a fraction of the cost of active management. In the listing of expenses above, index funds are going to be the prominent group with expenses under .5% ...
While most mutual fund companies are strong advocates of actively managed funds (for obvious business reasons), more and more people are moving to passive management. In fact, some fund companies actually cater specifically to index investors - most notably, Vanguard and DFA Funds.
Every year, Standard and Poors publishes a scorecard that declares the "winner" of the Index vs. Active Management "battle" ...
The winner? If you've done any reading in this area, you already know the answer. The winner this time around is consistently the winner [and not who most people would assume] ... PASSIVE MANAGEMENT! Over the five year market cycle from 2004 to 2008, the S&P 500 outperformed 71.9% of actively managed large cap funds, the S&P MidCap 400 outperformed 79.1% of actively managed mid cap funds and the S&P SmallCap 600 outperformed 85.5% of actively managed small cap funds! These results are similar to that of the previous five year cycle from 1999 to 2003. International stock funds? Same results - indices outperformed the majority of actively managed funds. In addition, S&P did not factor in the sales fees that "loaded funds" charge investors, which would have made the contrast even more startling. (Click here for an archive of past scorecards).
According to Princeton University's Burton Malkiel, the average actively managed mutual fund has returned 1.8% per year less than the S&P 500. 1.8% per year may not sound like a big deal, but it is a HUGE deal over time. A pretty compelling argument for passive management.
NOTE. Although index funds typically carry lower costs (and should), don't jump in without knowing what the specific costs are. While some index funds will charge as little as .1% or .2% in expenses, I am aware of a couple index funds (nothing special, just 'plain vanilla' S&P 500 funds) whose expense ratios are 1.06% and 1.50% respectively! So never assume the costs will be low merely because it is passively managed. It obviously would not make a lot of sense to pay “active management fees” for an index fund.