Whether you prefer active investing or passive investing, or aren’t investing at all, it’s pretty clear that the stock market is unpredictable. However, some people are convinced they have what it takes to beat it. They may look up company reports, scour for little-known information, and study trends and ratios for hours at a time. Many moves and trades later, these investors may believe that they have actually beaten the market, but this is usually because they haven’t actually experienced being invested during a bear market. It’s easy to think you’re a fabulous investor during a bull market when everything is going up.
Sometimes savvy folks actually do beat the general market. For example, their returns may be far better than the earnings of the Dow or the S&P 500. But, are their brilliant trades repeatable? Is excellent performance even sustainable from one year to the next? Bull markets don’t last forever, and we could be facing declining growth in the months ahead.
Does Past Performance Matter?
A study performed by the S&P Dow Jones Indices explored the question, “Does past performance matter?” When researching for the study, the analysts selected domestic stock funds that performed within the top 25% of other like-traded funds in 2010. Then, these analysts observed how many of these managed funds remained in the top 25% over the course of the next four years.
Out of the original 2,862 funds that were selected for the study, only 2 performed in the top 25% of the domestic stock funds in each of the five years. Even among highly skilled fund managers, past performance is not easily repeatable when it comes to the intricacies of the ever-changing stock market. Take a look at the below chart that the NY Times put together based on the study.
In the same light, questions often arise regarding actively managed funds vs. a benchmark index (the common reference of index returns is the S&P 500). On average, which funds provide the highest returns: the Index or an actively managed stock fund?
The basic premise is that actively managed funds would provide a higher return because there is an incredibly intelligent fund manager at the helm of each transaction. When the market takes an unexpected turn, the fund manager can make an immediate change, thereby saving investors from losses that they would have otherwise experienced had they been investing on their own.
Theoretically, professional fund managers should also be able to spot trends in the market and trade for higher gains than the Average Joe, who isn’t able to devote the same amount of time to such research.
Comparing Passive Versus Active Investment Returns
Research has shown that average actively managed funds have outperformed passive indices, but only by 0.12%. And note that figure is prior to factoring in the different fees associated with the active trades made by the fund managers.
Since fees and investment costs can really impact your portfolio’s returns over time, it’s important to incorporate those expenses into our analysis of active versus passive investing. As seen in the graph above, approximately 46% of active funds earned a return between 0% and 5% after all of the fees were considered. Another 41% of active funds earned a return between 5% and 10%. That might sound good by itself, but passive index funds clearly blow active investing out of the water in the 5-10% range.
If the general stock market earns 8% over the course of a year, then the average actively traded mutual fund would earn 8.12% (slightly above the average) based on the study referenced above prior to fees. However, since many mutual funds charge between 1% and 3% in fees, the average returns of these funds land below that of the general market, therefore creating the negative-sum game.
What Types Of Fees Are Funds Charging?
When investing in actively traded mutual funds, there are many fees to be aware of that could ultimately minimize your returns. Don’t overlook the importance of minimizing how much you’re paying to invest. Fees and account charges can really take a huge bit out of your money’s growth potential over time. Here are four common types of fees you should be aware of:
1) Expense Ratios – These are often the most visible fees within your investments. Expressed as a ratio (such as 0.90), this number represents a percentage fee, which covers the costs associated with running the mutual fund. These fees cover salaries of the fund’s employees, and also other costs of operation such as computers, the building lease, and office supplies.
2) 12B1 Fees – Not every mutual fund charges 12B1 fees, but many do, which can cost another 0.25% of your investment. These fees cover marketing expenses such as online ads, magazine ads, and television commercials.
3) Trading Costs – As the managers make trades on your behalf, costs are naturally incurred (just as you would incur a cost for making a trade yourself). These often account for another 0.2% that is charged to your account.
4) Sales Commissions – If you choose to have a broker invest money on your behalf, then you’ll likely be charged a fee for their services as well. Also, don’t forget that your broker may be monetarily incentivized to select certain funds over others. They may be tempted to select funds that pay them more, rather than funds that could perform the best for you. If this happens, not only are you paying a fee for their services, but your broker might also be costing you money by choosing an underperforming fund.
Earn Great Market Returns While Also Avoiding High Fees
To avoid the negative-sum game of actively managed funds, you might consider investing in ETFs that will perform along with the market for a very low fee such as SPY, which tracks the S&P 500 index or VTI, the Vanguard Total Stock Market ETF.
Open A Low Cost Investment Account And Save On Fees – Traditional wealth managers charge high fees and require high minimums as well, often at least $250,000 and sometimes $1,000,000. The good news is fintech companies have changed the way people invest – offering low fees and low minimums. Are robo-advisors safe? Yes! They offer a lot of flexibility and control, taking the work out of managing your money. Learn more about the best wealth management firms today.
Start Using Free Financial Tools To Grow Your Wealth – I highly recommend opening a free account with Personal Capital to help track all of your money in one safe and secure place in the cloud. If you want to learn more about how their service works, this Personal Capital review is really thorough and goes in depth.
Get A Free Personalized Investment Plan – Wealthfront is an excellent choice for personal wealth management for those who want the lowest fees and can’t be bothered with actively managing their money themselves. In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being invested in the market.
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Untemplaters, do you prefer active or passive investing or perhaps a bit of both? Have you been sitting on your cash or have you been regularly investing it into the markets? Which do you think is better for your money – active investing or passive investing?
I believe for most people, passive is the way to go. There will always be a segment of active funds that will outperform the market in a given year, but its difficult to predict who & what will. Why I prefer index funds is that you’re going to get the index return, minus fees. If you commit to a long-term plan with index funds, its highly likely you’ll get solid returns.
Yep, I agree. Most people are better off going the passive route. I do a little bit of active investing, but am mostly a passive investor.
All research I have seen so far indicates that passive investing is the way to go for most people. Historically investing has been a safe way to grow your wealth provided you do it over a long period of time. And since you as ‘ordinary civilian’ have very little to say about the market it is a good idea to focus on the costs instead because those can really bite away your returns. The problem is however that for many people this seems to simple and boring so they go for active investing instead (who doesn’t want to be the guy that can say he bought Microsoft at their IPO and is now a multimillionaire). Currently I a too young (and not wealthy enough) but in the future I’d like to use the 90/10 but for now I’ll stick to a 100% index fund investing.
Yeah, time really does make a big difference when it comes to investing. I like the set it and forget it approach to passive investing. I can see how active investing could be a lot of fun, but it certainly is no easy task to try and beat the markets!
I think there are a couple of ways to view this in the context of age. When we’re young we do tend to prefer more excitement, have a higher tolerance for risk, and think we know more than we do. All of these things would point towards active investing. While it’s true that you may make higher returns with active/individual stock investing, you may also lose money during the highly important “nut building” phase.
Which would you rather have at 30?
A “safe” $20,000 nut created by steady, passive investment.
A “risky” $40,000 nut created by active, more speculative investment (with a 50% chance at only $10,000)
It all comes down to your mindset, but I have a hard time sitting on my hands!
If I was younger again, I think I would still go for the safe route of $20k. I’ve been pretty safe and low-risk with my investment style most of the time. But the allure of making more is definitely tempting! That’s why I like a blend of both – mostly passive, but with a little active thrown in the mix to keep things exciting.
Financial Samurai says
I like the ratio of 90% passive, 10% active. There are fortunes to made every day, but you can only find those fortunes through active investing!
Good call, I agree that’s a good ratio. I don’t think I have the skills to find a fortune maker in the markets but I do dabble a little into active investing every once in a while.