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Investing Success: why index funds outperform managed funds

Index funds v managed funds

Investment funds are generally actively managed or passive index trackers. In the former, a fund manager selects stocks utilising the twin arts of market timing and trying to pick stocks that will outperform the market.

Passive funds do not employ managers to pick stocks, but instead aim to replicate and track an index, for example, the S&P 500 Index which is a US stock index comprising the 500 biggest public companies in the US.

The evidence on the performance of managed funds

If you own an actively managed fund, odds are that your returns lagged in 2021: about 80% of all actively managed US funds underperformed their benchmark index in 2021, and the chances of a managed fund beating an index are even worse over a multi-year time frame.

Fact: 75% - 85% of managed funds struggled to beat their benchmark index over 10-year periods, as highlighted in the prestigious S&P Indices V Active Funds (SPIVA) report.

Over the 10-year period from 2010 to 2020, the S&P 500 index delivered an impressive annualised return of 13.6%, resulting in a cumulative return of 347%. In the realm of managed funds, the highest performer achieved an annualised return of 10.8%, while the average return hovered around 9.5% per year resulting in an average cumulative return of 226%. Despite the best efforts of skilled fund managers, they were unable to surpass the consistent growth of the index.

The results are even more damning over a 20-year period:

Underperformance of managed funds

The precise numbers vary when you drill down into specific fund sectors, but the overall message is always very consistent: the average index tracker will tend to outperform the average actively managed fund.

The paradox of skill and the decline of managed funds

Since the mid-1960s, the average outperformance of the best US managed funds has exhibited a slow decline. This decline can be explained by the paradox of skill.

In the 1950s and 60s, professional investors on Wall Street, and in London, possessed a substantial advantage over their competitors. They enjoyed superior education, training, and access to advanced technology and information. At that time, having a telephone and an extensive network of contacts provided a remarkable edge. However, the advent of the internet and the widespread adoption of computers has leveled the playing field. Instantaneous access to information, learning resources on platforms like YouTube, and convenient investment apps have democratised investing and eroded the advantage once held by professional investors.

Understanding the dynamic nature of investing

Investing constantly evolves, popular investments and strategies come and go; no single investment or strategy can maintain consistent superiority over others, year after year.

It is only natural to be drawn to investments that appear to generate substantial returns. Whether it's individual stocks, cryptocurrencies, or other trendy options, there will always be investments that outshine index funds in any given year. Acknowledging these instances is important, but it should not drive us to make impulsive decisions.

Index funds represent the average performance of a specific market or sector, making them unlikely to be the top performers in a given year. However, when evaluating investment performance over a decade or more, it becomes evident that only a handful of strategies consistently outperform low-cost index funds.

The desire to keep up with others or the fear of missing out can create emotional turmoil for investors. Comparing our investment performance to others or succumbing to greed can cloud our judgment. However, by focusing on a long-term financial plan, we can mitigate these emotional challenges and remain committed to our strategies.

Successful index fund investing requires adopting a long-term perspective. By embracing a buy-and-hold strategy and avoiding market timing, investors position themselves for success. Chasing the latest investment trends often leads to suboptimal outcomes.

Fees: The hidden catalyst

Picture this: two identical cars racing down a highway, but here's the twist - one of them carries a heavier load, dragging it down with extra baggage. This is precisely what happens with active funds and their higher fees. According to Morningstar, the average index fund charges a mere 0.12% fee, while active funds demand a weighty 0.62%. To bridge the gap and match the index fund's return, the average active fund must earn an extra 0.5%.

Fees matter.

Fees matter

The odds are against individual stock pickers too

To achieve above-average returns, stock pickers must recognise that they are not competing against the average individual investor. Instead, they are competing against institutional investors who control the majority of invested cash. In 1950, individual investors owned 93% of US stocks, with institutions owning the remaining 7%. However, as of 2019, individual investors comprised only 10% of trading activity. Skilled institutional investors manage the vast majority of funds, making it necessary for individual investors to outperform these experienced market players to achieve exceptional results.

Research shows that when individual investors are pitted against institutional investors, the latter consistently outperforms the former. While there may still be highly skilled individuals who exploit market inefficiencies, the intense competition among investors makes it more challenging than ever to achieve such status.

Index funds outperform managed funds

Long-term success as an investor requires accepting the reality that index funds may not consistently rank at the top in any given year. However, the simplest approach to investing also happens to be the best. By investing in an index fund, ideally a global diversified (spreading the risk) low cost passive index fund, consistently over a long period of time, investors can beat the returns achieved by many active investors.

Allocating a small portion, perhaps 5-10%, of your portfolio to individual stock picks, cryptocurrencies, or other investments could provide the element of fun if desired.


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