This is the third post examining the arguments given by fund managers against leaving their funds and investing in an index.
Argument #4: Over such and such a time period active funds beat index funds.
It is true that over some periods of time, actively managed mutual funds give higher returns than index funds. When making this kind of argument, the fund manager has to select the time period carefully, because most of the time, index funds win out. Where actively managed funds tend to win is in periods where the stock market performs poorly. This is because most funds have to hold some cash (often around 10% of the money in the fund) to deal with the volatility of investors entering and leaving the fund. So over a period of time where stocks don’t do as well as interest on cash, a fund with 90% of its money in stocks and 10% in cash will beat an index fund with nearly 100% in stocks.
However, stocks have been much better long-term performers than cash. The cash component of actively managed funds is actually a factor in their long-term underperformance compared to index funds. For the investor who prefers to buffer bad times in the stock market by holding cash, a solution with lower fees than owning actively managed mutual funds is to own index funds along with some cash.
Argument #5: Some index funds do not have low costs.
This is certainly true. There are fund companies who have tried to jump on the indexing bandwagon and offer index funds, but with high costs to trap the unwary. This is a nice job if you can get it – charging high management fees without having to do much management.
This argument is like saying that medicine is bad because some people sell bad medicine. Investors in index funds just need to pay attention to management expense ratios (MERs) and avoid funds with high expenses.
In summary, I’m not against active stock picking. What I am wary of is paying a high price in the form of management expenses and other fees for the services of an active fund manager.