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"Yes, there will be portfolio managers who beat the market, but the percentage seems to be lower, and the distribution less reliable, than the flipping of coins."
- Bob Veres, Financial Industry Reporter
At Headwater Investment Consulting, we build portfolios using index funds because markets are generally efficient; and after taxes, fees and trading costs, the active managers rarely out-perform the indices.
Better Than "Average" Performance
While index funds track market "averages," they deliver better than average performance. As of August 2002, The Vanguard S&P 500 Index Fund outperformed 81% of all U.S. diversified stock funds over the last 20 years1. From 1987-1999, a passive 60/40 stocks/bonds portfolio outperformed 90% of the nations largest pension funds2. The trustees of these pension funds are very sophisticated investors and have the resources to hire the best investment managers available. Yet, highly motivated and educated professionals continually fail to beat the market.
Lower Costs
Without high paid stock-pickers and swarms of analysts, Index funds are able to have lower expense ratios than their actively managed peers.
|
Expense Ratio3
|
| Average Equity Mutual Fund |
1.47% |
| Vanguard S&P 500 Index Fund |
0.18% |
In addition to lower expense ratios, with index funds the unseen cost of trading is lower. Every time a fund buys or sells a security, it incurs a transaction cost. Index funds have low portfolio turnover, i.e. they do not buy & sell securities very often, minimizing the amount of investor money spent on transactions.
|
Trading Costs4
|
| Average LargeCap Equity Fund |
0.94% |
| Vanguard S&P 500 Index Fund |
0.05% |
In short, high investment costs are NOT a fact of life and should NOT be tolerated. In addition, more fees and more trading activity does not purchase better investment performance. It is your money. Keep it.
Tax Efficiency
By their very nature, index funds are also more tax efficient than actively managed funds. Because index funds buy and hold the stocks of a particular market index, there is less trading activity resulting in fewer opportunities to tax your investment. Taxes on capital gain and income distributions resulting from frequent trades can substantially lower returns. The median tax cost ratio for U.S. equity mutual funds is .98%5. In other words, if the median fund returned 8% for a given year, the after-tax return would be approximately 7%. One percent compounded over a number of years is significant money. To beat index funds, active managers must not only guess the future, they must guess the future plus 1%.
Peter Lynch puts it best. Upon retirement from managing Fidelity Magellan, then America's best performing stock fund, he said, "Most investors would be better off in an index fund."
1. The study comparing the Vanguard S&P 500 Index Fund and all U.S. diversified stock funds was done by Vanguard using Lippper data.
2. The pension fund study referred to in Performance part 3 looked at 243 pension funds and was conducted by Dimensional Fund Advisors, Piscataqua Research.
3. The tax cost ratio is calculated using Morningstar data as of 02/28/2003. The analysis included all U.S. equity mutual funds with a calculated 3 year tax cost ratio and is the median of 5240 funds.
4. The expense ratio for the Average Equity Mutual Fund was calculated using Morningstar data and is the average of 8432 U.S. equity mutual funds as of 02/28/03. The Vanguard S&P 500 Fund is calculated by Morningstar and is current as of 02/28/02.
5. Trading Costs are calculated using data from www.personalfund.com and a 2002 study by Stefan Sharkansky, Rev1.1 The Trading Costs are calculated based on largecap equity numbers in his study, 1.24% per 100% turnover and the 76% turnover for the average largecap equity fund. 1.24% x 76% = .94% The Vanguard S&P 500 Index Fund had estimated transaction costs of .05% as of March 2003; according to www.personalfund.com.
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