Advantages Of Index Funds Over Active Funds

I invest my own portfolio in index funds whenever possible and suggest most other investors do as well. That their long-term performance records dominate the average actively-managed fund is the stuff of legend at this point. The primary reason index funds make such good long-term investments, of course, is their low costs. Yeah, there are some high-cost index funds out there, but most index funds offered by reputable firms such as Vanguard, Fidelity, and Charles Schwab are dirt cheap. Costs matter, and index funds dominate in this regard.

Other Advantages Of Index Funds

But it’s not just a cost story. Yes, costs are important and probably constitute 95% of the advantage the average index fund has over the average actively-managed fund, but there are plenty of quality low-cost active funds around, especially from companies like Vanguard and Dodge & Cox. So are there other inherent advantages to indexing over active management? I believe so, but they are admittedly small.  Still, over the long term every little bit counts. Here are a few of those advantages.

Index Funds Avoid Style Drift

Style drift happens when a mutual fund shifts from its stated (or simply prior in the case of so-called “go anywhere” funds) investment style or objective. For example, consider the case of an actively-managed large-cap value fund in the late 90′s when growth stocks were all the rage. Many value managers at the time were tempted to delve a bit into growthier issues in an attempt to keep up with their peers. As it turns out, mutual fund managers aren’t any better at market timing than retail investors. In an industry where focus and discipline are absolutely necessary to succeed, style drift kills.

Besides, when you deploy a portion of your money, don’t you want to know which specific asset class that money will be invested in? I do.

Index Funds Avoid Management Risk

There is no better example of management risk rising up to smack investors in the face than the famous case of the Fidelity Magellan fund (FMAGX). After putting up absolutely insane performance numbers throughout the 80′s (averaging 29.2% from 1977-1990), Peter Lynch retired and the fund promptly returned to churning out more mediocre returns. Magellan’s stellar long-term track record in the early 1990′s was primarily due to Peter Lynch and a few previous managers, not whomever the current manager was (and there was significant turnover for a while). Thus, the past record was almost completely irrelevant when evaluating the fund with respect to its probable future performance.

When a star manager leaves a fund, performance can often change dramatically. Since they merely follow a passive benchmark, index funds don’t have any management risk. They will match the market, minus expenses, ad infinitum. Hot active funds? Probably not.

Index Funds Avoid The “Closet Indexing” Problem

This one is mostly a cost issue, albeit indirectly. The larger actively-managed funds have such  large asset bases that their portfolios tend to become “closet index funds” over time, meaning they closely mimic the performance of their target benchmark. Asset bloat is a serious problem with actively-managed mutual funds and really, when you think about it, how could things be any different? Due to various rules restricting what percentage of a company’s shares any given mutual fund is legally allowed to own as well as what percentage of a fund’s portfolio is allowed to be invested in any one company, large mutual funds end up having to own hundreds of stocks. It stands to reason that the greater the percentage of the companies in a given index a fund owns, the closer that fund’s performance will track the benchmark.

As an example, suppose there are 1000 stocks in a particular value index (a typical amount). Assume also that a large-cap value fund with, say, $30 billion in assets owns approximately 250 of those stocks (also a typical amount). That means the fund owns a full 25% of the stocks in the index, which from a statistical perspective is a sizable sample. Statistically, we would expect the fund to closely mimic the movements of its target benchmark. Smaller funds are able to get away with owning a much smaller percentage of the stocks in their target markets, of course, but strong performance also stimulates strong asset growth as new investors pile into the hot-performing fund.

But wait, isn’t indexing desirable? Well yes, but only if it’s also cheap. The problem with closet indexing is that all but completely lose the possibility of out-performing its index fund counterpart. After all, a bloated active fund that basically owns the entire index can’t very well beat that index, can it? And the real index fund has a significant advantage: it has much, much lowers costs. For bloated funds, the cost disadvantage is pretty much impossible to overcome.

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