Wednesday, November 21, 2007

More Fund Manager Arguments Against Indexing

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.


  1. Well, if all this IS true? Then how come Vanguards Bal Funds, VWELX & VWINX have Beaten their Comparative Index Portfolio's for the past 10 yrs and counting now?

    And How come Other Active MGes Funds like FPACX, OAKBX, PRPFX have done the same vs their Compartive % allocaiton mix Index Ports?

    #1 Reason? They sliminate the Primary reason Indexing , let alone anyother form of Hands On Investing.. The Human Factor interfering and just let the pro's handle it, who have better control being a 3rd party person in charge of your $..

    That to me? Is the Biggest problem with Invesitng into seprate Sectors and classes, be they Indexes or Non Index funds.

  2. Anonymous: Out of a universe of thousands of funds, a few are bound to outperform indexes even over 10 years. However, these are past returns. Who says that these funds will outperform in the future. How can you choose the funds that will outperform in the future.

    I agree that hands-off investing is the way to go. Unfortunately, investors who place their money in mutual funds often jump around from one fund to the next always chasing last year's winner. So, the idea of placing your money with a pro and leaving it alone is nice in theory, but often it doesn't happen this way in practice.