Active Mutual Funds Suck Compared To Index Funds

You have probably heard before that most mutual funds do not beat the market. Well, it’s true again, or true still, whichever you prefer.

The S&P Dow Jones Indexes (yes, they might be a little biased, but they make their data available, and no one says it’s wrong) put out a report called SPIVA U.S. Year-End 2021 in which they state that nearly 80% of all actively managed domestic equity funds lagged the S&P 1500 in 2021. Even worse, 98.6% of actively managed large-cap growth funds failed to beat the S&P 500 Growth. If that sounds too specific for you, 85% of actively managed large-cap funds trailed the S&P 500. The numbers aren’t much better for other categories.

This year, the SPVIA leaves no room to “Yeah, but…” by putting to bed the notion that actively managed mutual funds better handle volatility noting that whether it’s 3-year, 5-year, 10-year, or 20-year risk-adjusted returns, active funds underperform the index.

Active Mutual Funds Suck Compared To Index Funds 2

Survivorship Bias

The reality is that the situation is actually much worse. Every year approximately 5% of actively managed mutual funds disappear via merger or liquidation. If you think mutual fund companies are merging or liquidating their winning funds, then I have some beachfront property to sell you in Arizona.

In fact, according to SPVIA, almost 70% of domestic equity funds have disappeared over the last 20 years. For every, “Hey! Look at our 5-Star Morningstar mutual fund with a winning track record,” there’s one (or more) loser funds that were simply erased from view, and from the company’s track record.

How To Invest In Mutual Funds

Now what?

If actively managed mutual funds are so terrible (they are) then how are you supposed to invest money for retirement and education. The answer is to use index funds or ETFs whenever possible. A large-cap index fund is likely to outperform the XYZ Super Best Large Cap Fund.

Many 401(k) plans and college savings plans allow you to choose index funds. California’s Savings Plus 401(k) plan, for example, offers a Large Cap Index Fund, Mid Cap Index Fund, International Index Fund, and Small Cap Index Fund in addition to traditionally managed funds like the Large Cap Fund. The same is true for many corporate and government 401(k) plans, like Colorado’s PERAPlus 401(k) plan and many others.

Just because an actively managed fund is likely to trail the indexes isn’t necessarily a reason to never invest using one, especially if you don’t have other options. In that case, be very mindful of the expenses of the mutual fund, often expressed as an expense ratio. One of the reasons active funds trail index funds is higher expenses. The lower a fund’s expenses, the less of a disadvantage. Keep in mind the converse is true. The more expensive an index fund or ETF, the less of an advantage it has over actively traded funds.

The reason mutual funds usually trail the indexes is size. If I sit here, behind my office keyboard waiting for a good investment opportunity, it costs me nothing. For a mutual fund to be as choosy is nearly impossible either leaving too much money in cash or making investments so large that they artificially move the market. Thus, actively managed funds are forced to invest in their 2nd, 3rd, and 4th best ideas.

As always, a well-diversified portfolio tailored to your long-term investment goals is the best way to invest for retirement and other long term goals.

About the Author

By Brian Nelson – Brian is a former Certified Financial Planner and financial advisor. These days he is a freelance writer specializing in technology and financial publications. The material provided on this website is for informational use only and is not investment advice. Consult with your own financial professional when making decisions regarding your financial or investment options.

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