Managed versus Index Funds

The big idea of an index is to track the overall performance of the market or some sector of the market.  Recall that at the macro level, the overall market trends such that individual stocks go up and down together, at least in the short term.  A few Titans of Wall Street have demonstrated that a great stock picker can beat the market.

When investors talk about beating the market, they are talking about beating the return of some benchmark index.  The evening news and the average Joe tend to pay a lot of attention to the Dow Jones Industrial Index ($DJI).  Most serious traders and financial experts tend to reference the S&P 500 as the ultimate reflection of what the market (overall) is doing at any particular time.

When financial advisors talk about “managed funds,” they are talking about a type of mutual fund that is overseen by a stock picker.  The idea is that these financial professionals will beat the market for you, and you will realize higher returns than if you had just bought all of the stocks in a particular index.  (The difference between an index and a fund’s (or stock’s) performance is referred to as alpha).  The problem is that most stock pickers don’t do such an outstanding job and they almost never beat the market.  To add insult to injury, they charge fees, so you actually do worse than the market a lot of the time.

Active vs. Passive Investing

An active investment strategy relies on the skill of an investment manager to construct and manage the portfolio of a fund to provide exposure to certain types of investments or outperform an investment benchmark or index.  An actively managed fund has the potential to beat the market, but its performance is dependent on the skill of the manager.  Also, actively managed funds historically have had higher management fees, which can significantly lower investment returns.

The shareholder is paying for more active management of portfolio assets, which often leads to higher turnover costs in the portfolio and potentially adverse federal income tax consequences.  Passive investing is an investment strategy that is designed to achieve approximately the same return as a particular market index, before fees.  The approach can be implemented by replication—purchasing 100% of the securities in the same proportion as in the index or benchmark—or by a representative sampling of stocks in the index.

Passive investing also typically comes with lower management fees.  As discussed above, passively managed mutual funds generally are called index funds.  Most ETFs are also passively maintained, although there are some actively managed ETFs on the market.  Passively managed ETFs usually have lower costs for the same reasons index mutual funds do.  Also, index-based ETFs’ costs and taxes can be even lower than index mutual funds’ because of the manner in which ETFs operate.

The best advice when it comes to choosing a stock mutual fund is to find a fund that mirrors the S&P 500 and has low fees.  Stick all of your money into that, and leave it alone.  Some people disagree with this logic because such a strategy isn’t diversified enough—the approach is “too risky.”  Keep in mind that the very nature of an S&P 500 index fund is to expose you to 500 different companies.  That’s pretty diverse!

It does expose you entirely to stocks.  This means when the market goes down, the value of your portfolio will go down in lockstep.  Recall that your portfolio (if you are invested in equities) reflects your ownership of stocks, not dollars.  Peaks and valleys in the short-term charts of the individual companies and the indices are nothing to be overly concerned about.  When you are saving for retirement, you need to think of the long, long-term view.  Several high profile unicorn investors recommend this strategy for young investors.

Since equities were first traded in America (which was before it was the United States of America), the stock market has performed admirably over the long haul.  There have been many highs and many lows, but over the long term, the trend line always points up.  My take on this is simple.  As populations grown and more people participate in the economy, the economy grows (This is why I think restricting immigration is stupid; America needs to grow as fast as our competitors in the East if we are to retain the world’s biggest economy).

As technology advances and we produce more per capita, the economy grows.  The bottom line is that as long as technology advances and more people are providing more goods and services, the economy cannot help but grow.  That growth will be reflected in the stock market given enough time, and the regression line will always have a positive slope.

Financial advisors are trained to tell their clients that they should have a “diversified portfolio.”  They bristle at a portfolio composed entirely of equities.  After all, conservative investors need a balanced portfolio of bonds, annuities, perhaps some real estate—only a fraction of these selections should be stocks.  I am no financial advisor, but I disagree wholeheartedly in the case of the youngest of investors.  I suggest you put everything into the maximum yield you can get with an adequate margin of safety.

To my view, this means put it all in an S&P 500 index fund with the lowest cost possible.  Unless interest rates top 10%, bonds, CDs, and savings accounts are an “old man’s game.”  If you go to a “really safe” retirement account asset allocation, you’ll retire poor.  It really is that simple.  This is another reason that you really need to understand all of this stuff:  Being “conservative” and “preserving capital” sound like very good things to those who don’t know any better!

Another reason that I suggest this for those just starting to invest is that you cannot afford to diversify into good funds until you build sufficient capital.  The very low-cost Vanguard funds that I prefer usually have minimum investment requirements, and you cannot afford that when you are just starting out.  I suggest that you “buy the SPY” until such time that you can afford to start allocating across a properly diversified portfolio.

This is a good place for a note about “financial advisors.”  For the most part, these good folks are trying to make a good living for their families.  Very few of them have degrees in finance (especially graduate degrees, such as MBAs), and most of what they know they learned from their company.  The question you must ask yourself is, “how does my financial advisor get paid?”  Often, they are paid on a commission.  It’s all about how much money they can bring under management.  Often, it is also about how much money they can bring under management in the “investment products” that their companies sell.

My father was in insurance sales for a long time, and he was very good at it.  He went to a training where the company gurus taught him all about the amazing annuity products he could sell and make big bonuses.  He had a lot of faith in those products and sold them with conviction.  He felt good that he was helping people secure their future.  Many of his customers were poor blue-collar folks from Mississippi, so in a way he was right.

They often did not have a 401(k) and would not have saved anything for retirement any other way had he not intervened.  He genuinely cared about his customers; they were members of the community and his friends.  The company he worked for was a huge, publicly traded concern that cared far more about their bottom line than their customers’ savings.  Those customers did save money, and they even made a little.  They probably even hedged inflation.  We are smarter than those folks, and we can do much, much better.

Even if you are willing to take on a lot of risk for a big reward by investing almost entirely in stocks, about ten years from retirement you must start changing the way you think about your retirement account.  At this point, you will want to start looking for points where your index fund is doing really, really well.  Each time the S&P 500 (or whatever index your funds follow) hits a new high, you want to move a couple of percent of your portfolio into “conservative” investments that guarantee your capital.

For a rule of thumb outside of a bona fide investment plan, I suggest about 2.5% per year during this ten year period if you want to take on risk and maximize the value of your portfolio on retirement, and about 5% if you are really, really conservative.  This is the simplest plan, but it is perhaps not the best.  We will discuss allocation over your lifespan in much more detail in a later section.

Some people feel like their retirement date is the date by which they should have all of their money in “safe” investments.  Keep in mind that your retirement account should be designed to last you from the time you retire until the time that you ultimately die.  My wish for you is that this is nice, long time and you really get to enjoy the fruits of your lifetime’s labor and your grandchildren.  If you retire at 65 and live to be 85 years old, you will be retired for 20 years.

Why, then, would you pull your money entirely out of the market and let it waste away because of inflation?  Having 25% (or 50% if you have an anxious personality type) of your funds in bonds and other guaranteed income producers will get you through any market downturns.  The idea that the S&P 500 could tank and stay at rock bottom for 20 years is possible, but I’d put that up there with the same likelihood as the new black plague killing half the Earth’s population, a catastrophic meteor strike, or a zombie apocalypse.

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