If you’re like many investors you have your favorite investment column or magazine and
you watch patiently for their recommendations on the latest hot mutual fund. It will most
certainly be a Morningstar® five-star-rated fund and will have provided stellar returns for
the last couple of years. But how will it do in the long run? Often the great performing
fund of today becomes the laggard of next year or the year after. And today’s bottom-
ranked funds often pop up on the best-performing list a year or two down the road.
So what should you do? Perhaps you should take a lesson from John Bogle, founder of
The Vanguard Group, Inc., the world’s largest no-load mutual fund group. Bogle
created the first index mutual fund in 1975, based on the Standard & Poors 500 Stock
Index. An index fund attempts to replicate the performance of the associated index by
buying the same stocks that are included in the index.
In his book titled Common Sense on Mutual Funds – New Imperatives for the Intelligent
Investor, John Wiley & Sons, 1999, Bogle points out that as of 1995, the Standard and
Poors 500 Index had outpaced 96 percent of all actively managed mutual funds.
Actively managed funds buy and sell stocks based on various selection criteria with a
goal of beating a target index.
Nearly all index funds are passively managed, meaning that trades are performed to
replicate the index. Once that is done, adjustments are made as investors buy in to the
fund or liquidate their shares. Trades are not made because the fund manager likes or
dislikes a particular stock. As a result, transaction costs are kept to a minimum.
Since index funds merely have to replicate an index, management fees are also kept
low. There is no need to visit companies to be included in the fund and no need to do
research.
The expense ratios (annual percentage charge for all fund management fees) for most
index funds are substantially lower than the expense ratios of actively managed funds.
For example, the expense ratio for the average mutual fund is often1.00% or more. In
comparison, the expense ratio for the Vanguard 500 Index Fund is 0.18% and for the
Fidelity Spartan 500 Index fund, it’s 0.10%. A one percent difference in fund fees can
have a huge impact on returns for the long-term investor.
Taxes are another consideration. Since index funds generally trade significantly less
than actively managed funds, realized capital gains are usually much lower than for
actively managed funds. As a result, index funds often are much more tax-efficient than
actively managed funds.
These two factors, fund expenses and tax efficiency, together can eat away a
substantial amount of a fund’s return.
We are increasingly recommending more use of index funds in our client’s portfolios.
Nevertheless, we still use actively managed funds to complement index funds and
Exchange Traded Funds (ETFs). (Note: We will discuss ETFs in a future article.) Each
year we perform an extensive research of available mutual funds to choose the best low-
cost, no load (no commission), no-fee funds we can find. We review approximately
fifteen different fund characteristics to narrow down the multitude of available funds. A
fund’s Morningstar rating is just one minor piece of the data we consider. It’s a difficult
job! In his book titled Unconventional Success – A Fundamental Approach to Personal
Investment, renowned investment manager of the Yale Endowment Fund, David
Swensen summed up the challenge of picking good actively managed mutual funds:
“Identifying active-management winners represents an incredibly tough assignment.”
So, unless you have an independent, unbiased and qualified investment advisor you
trust helping you to make investment decisions, you’ll likely do much better sticking to
low cost index funds. Over the long run, index funds will likely do better than the Money
Magazine mutual fund pick of the year. Not because it’s not a good fund but more likely
because taxes and fees will eat away at the funds returns. It’s tough to beat index
funds!
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, October, 2007
Tough to Beat Index Funds
By David and Erin Patterson