Investing in mutual funds can be complicated, but it doesn't need to be. If you want to spend your investment dollars wisely, buy low-cost index funds.
In any purchase, whether an automobile or a pair of jeans, consumers make buying decisions using certain criteria. They at least want decent quality at a fair price. But a smart shopper's dream is to find above-average quality at a below-average price--like buying a Camry for the price of a Corolla.
That adequately describes an index fund, which mimics an established benchmark, such as the Standard & Poor's 500 stock index.
The main alternative to buying an index fund is to buy an actively managed fund. Managed stock funds are operated by professional money managers who try to pick winning stocks. Winning is typically defined as beating the established index.
Think about that. You're paying professionals, and all they have to do is beat someone who does nothing. That's not an accomplishment. That's the least they could do for their pay. But most fail.
That sets up the long-standing argument between the stock-pickers and the indexers. And it's no wonder consumers are confused. Evidence supports the counterintuitive ideas that passive management is better than active management, and you don't get what you pay for--both of which are rarely true in other parts of consumers' lives.
"Professionals [usually] add value to our lives. The doctors, lawyers and dentists add value," said Gus Sauter, chief investment officer for the Vanguard Group, a leader in index funds. "But with money managers, the only way they can add value for one investor is to take it away from somebody else. Outperformance is a zero-sum game. So there is no aggregate value added.
"But people just assume that these professional money managers add value."
In 2006, 76 percent of active funds investing in large U.S. companies failed to beat a large-company stock index benchmark, the MSCI U.S. Prime Market 750, according to data from Morningstar Inc.
For large value funds, which try to pick undervalued stocks, 94 percent of active funds failed to beat the value index.Here are reasons to buy index funds, based on typical criteria consumers would use for any purchase:
It was big news at the end of last year when one stock-picker--Bill Miller, manager of the Legg Mason Value Trust mutual fund--failed to beat his benchmark. He had beaten the S&P 500 for 15 straight years.
So, it's extraordinary and newsworthy when a stock-picker can outperform an index over time. That means index funds are high quality because most actively managed funds can't beat them consistently. In many years, index funds beat about three-quarters of actively managed funds. And if you pick a fund that outperforms the index one year, it frequently has a hard time repeating that the following year.
Index funds are cheaper than actively managed funds because you don't have to pay a stock-picker or a bond-picker. And index funds don't buy and sell stocks as frequently as managed funds, so the transaction costs and tax effects are likely to be much lower. A key reason index funds are high quality is because they are cheap.
An index fund won't protect you from general market downturns, but you won't see years where your fund does terribly compared with the index. You're also protected against bad stock-pickers who stray from the types of stock you want to own. So, like the factory warranty on a refrigerator, you're protected from something unusually bad happening.
"You have a great deal of certainty in advance that the index fund will provide the type of return you're looking for," Sauter said. "There really are no surprises. You get what you actually want to buy and you get it at a reasonable price."
-- Cost of ownership.
A higher-cost managed fund isn't a one-time expense. You'll pay higher costs year after year due to the built-in expenses of the fund. It's like buying what you think is a nice car. But you know it will be expensive to operate, maybe needing frequent repairs and getting lousy gas mileage, compared with other cars.
"The longer the time period, the more important that cost [of ownership] is," Sauter said. "Over 20, 30 or 40 years, the costs become extremely important."
-- Ease and convenience of use.
The iPod digital music player is popular because it's easy to use. So are index funds. You could buy a single mutual fund that will give you the aggregate returns of all U.S. stocks, for example. If you want to invest in the stock of foreign companies, you can buy an international index fund.
"A broad-market index fund should really be your default option," Sauter said.
Why do investors choose actively managed funds? That's the question addressed in a 1998 study co-written by Donald Lichtenstein, a professor of marketing at the University of Colorado.
The study suggests one reason is that investors don't really know what a good return is and therefore are satisfied with their underperforming active funds when they shouldn't be. Most investors in one survey cited in the study either didn't have a reference point for assessing a good return or used low-yielding certificates of deposit as a measuring stick.
There's also the lottery, or gambling, mentality. An investor might think, "Why would I settle for beating only three-quarters of all mutual funds when I can take a shot at a big score and rank in the top, say, 5 percent? I'll never be able to brag at cocktail parties about my index-fund returns."
That risk-taker attitude is fine for a $1 lottery ticket, but is it a way to manage your nest egg for retirement or your children's college expenses?
Said Sauter, "A lot of it stems from a lack of understanding. People don't realize how tough it is [to beat an index]. In fact, it's an impossible game, on average, to outperform. The odds are that the professional will not earn his pay."But hope springs eternal."
Gregory Karp is a personal finance writer for The Morning Call, Allentown, Pa., a Tribune Co. newspaper. E-mail him at email@example.com. For additional discussion on spending wisely, see the Spending Smart blog at http://blogs.mcall.com/spendingsmart/.Copyright © 2015, Los Angeles Times