Tuesday, April 19, 2011

Index Investing vs. Active Money Management

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The biggest problem with investors today is confusion. A big issue that has left investors baffled is where they should place their money in order to make the most profit. Should you manage your portfolio personally or invest into an index? And which one will make more money. The only problem is that investing is not that simple. You can’t just invest your money in a particular fund. There are circumstances that come into play that can either benefit you or hurt you. This “age old” question has been under much scrutiny over the past couple of years. Where should you put your money? And Why? For avid investors who are looking to invest their money wisely and who plan on keeping their money tied up for a period of time, index funds are most beneficial. Index investing is very easy to learn, does not tie up a lot of your valuable time to manage; is tax efficient and based on past results index investing should give you higher returns. If that is not reason enough, I do not know what is.

Cost is a very important factor when it comes to investing. How much does an investor want to spend? According to Evanson Asset Management, “Active investors must overcome many costs to match the returns of the average passively managed portfolio. These include Trading costs, much higher management fees, market impact costs as active managers affect the prices they pay, dilution from maintaining higher cash positions than passive managers, taxes in taxable accounts due to high turnover rates, and, commissions, if an investment “product” is purchased through a broker” (“A Comparison of Active and Passive Investment Strategies” www.evansonasset.com/index.cfm). The cost of an actively managed professional portfolio typically range between 5% to 50% per year more than passively managed professional portfolios (Radcliffe). This can prove to be very costly to an investor who chooses to invest a large sum of money into the market. It can also be damaging to an investor’s assets over a period of time. If an investor is paying a money manager commission at the average, then that means that the active investor they are paying must outperform the index by this margin plus all other costs allocated over time. This can be a big problem for investors, especially when an index fund averages a dismal . Indexing still probably makes the most sense for core large-cap exposure. Its just so dominant over the long haul, even after hurting in recent years (investopedia.com/universities/indexes/). It is possible however, for an active fund manager to beat a relevant index over the long haul. Bill Miller, known the “The Man Who Beat the S&P 500,” has beaten the S&P consecutively since 10. This is very rare though. As noted earlier, in order for Mr. Miller to be able to outperform the S&P, he has to account for all the costs that he accrues by actively trading his funds. This is nearly impossible unless you know what you are doing. In fact less than 20% actively managed diversified large cap mutual funds have outperformed the S&P over the past ten years (investopedia.com/universities/indexes/). That is because in order for actively managed funds to beat an index it has to outperform a fund by the costs it accrues. All of the fees that an actively managed stock ensues, it has to outperform the fund by that amount. For instance, let’s say that if a fund charges, then you have to outperform the market by that percentage just to break even. Cost for an investor is very important and when they pay less to trade funds, they have more to invest, which in turn means they have more money to grow, which makes for a good investment.

Another factor in choosing where to invest your money is return. You want to invest into something that will make you money. That is just common sense. There is no one in their right mind that would put their money into the market where they know that they could possibly lose money. Peter Di Teresa reviewed “William Harding and Brian Portnoy studied when and where actively managed funds were competitive alternatives to index funds. Harding and Portnoy compared the actively managed funds in each of the nine Morningstar domestic-equity style-box categories (ranging from large value to small growth) with the relevant Russell indexes. For large-cap blend funds, they compared the funds with the standard S&P 500 benchmark, as well as with the Russell 1000. The Results were as expected; Harding and Portnoys study confirmed that indexing can be tough to beat over the long haul. Actively managed funds in the small-growth and small-blend categories beat the Russell 1000 Growth and Russell 1000 Indexes for the 10 years ending December 1, 001, and mid-growth funds came reasonably close to beating the Russell Midcap Growth Index, but that was it. In the other categories, the indexes clearly triumphed (http//news.morningstar.com/doc/article/0,,810,00.html).”


Another reason for S&P funds’ lofty return has a lot to do to with the great success of most large cap stocks. “The S&P 500 funds are on a tear because the companies that dominate the index are large, successful multi-nationals that are well positioned to thrive in the global community.” (Laderman).

Like most Wall Street propaganda, the latest onslaught of active managers will beat the market because of its recent rough shortcomings is a lie. Jason Zwieg, of Money Magazine, wrote, “Over the past 15 years, the S&P 500 fell in 2001. Just 7% of active funds beat the market in 1970 and 4% last year. Only in 2000 did a majority, 66%, beat the S&P 500 (Zwieg). In truth, the primary factor in determining whether active funds will beat the S&P 500 is how the smaller stocks perform. Since the S&P doesnt contain lots of small stocks, active funds almost always beat it in years when little stocks outperform big ones like in 1977.

Many experts however, do not believe in the numbers. Jonathan Clements of the Wall Street Journal writes, “Investing isnt just about making money. Its also fun. And what could be more fun than buying and selling stocks using your computer? He goes on to say that It sure beats sticking your money in an index fund and merely matching the performance of a market average. Clements then turns around and bashes index funds from the viewpoint of full-service brokerages, which he calls more comforting than an index fund. True, most investors would get better results by putting their money in a market-tracking index fund, he admits. But have you seen all the doggy stocks in those funds? Its so much more comforting to have a broker looking out for you. (Stewart http//groups.google.com/groups?q=index+investing&start=100&hl=en&lr=&ie=UTF-8). More comforting, but with worse results! How much would an investor have to pay for this cold comfort? I believe that this is not what investors want. Who cares about fun when you are making money? Investors are called investors for a reason. If they wanted to have fun they would go to Disney World! I believe that these investors really want is greater return. Index investing has a greater return and even critics of the index can not deny that.

Now do not get me wrong, active money management is not bad, if you know what you are doing. There are some cases where managed funds do beat out indexes, but it does not happen often (less than 10 percent). In a time where there is no money in the market, active investing can be very beneficial. According to Dunn’s Law, “When an asset fund is doing well, an index fund tracking that class should deliver superior returns. Likewise, when that asset class suffers, the index fund should do worse than its actively managed competitors (Di Teresa). To simplify, when things are good, they are great, but when they are bad they are even worse for an index. Active managed funds are a gamble if you “bet” right, you are a hero, but if not you are back to square one. This can make for an exciting adventure for an investor, compared to index investing.

Index investing just makes more sense. The returns are better, it is more cost efficient and not as high of a risk opposed to active trading. I know that there will be certain critics that do not believe that what I am saying is always true and believe that active money management is more beneficial. In some aspects they are correct, but overall index investing is just better to the investor. There will be some people that will challenge this by saying that the market is down and as of now active funds are more reliable, but if you are in it for the long run, index funds are the only way to go. The evidence is staring you right in the eyes. The numbers are there, index investing produces higher returns and less costs. Why every investor decides to invest money? It is to make more money and with an index and a little bit of patience they can sit back, enjoy life and watch their money work for them. The proof is in the pudding, index investing rather than active trading is much more beneficial to an investor.



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