Index Funds' Success Casts Shadows on Active-Fund Managers
By: Jeff Brown

NEW YORK (BankingMyWay) — If there’s any doubt about the ascendance of index-style investing, consider this report from Vanguard Group, the mutual fund giant: At the end of 2012, participants in 401(k)s administered by the firm devoted 60% of their assets to indexers, up from 30% in 2004.

During that period, the share of assets in actively managed funds dropped to 21% from 38%. (The remainder cannot be classified as either.)

An even better measure of the popularity of each type of fund is the allocation of new contributions, Vanguard said. From 2004 through 2012, the portion going to indexers rose to 64% from 32%, while that going to active funds dropped from 38% to 20%.

The results beg the question: Is there any benefit at all to using actively managed funds?

By now, most investors know the difference. Actively managed funds employ teams of analysts and money managers to seek hot stocks and bonds. Index funds simply buy and hold the securities in a market gauge such as the Standard & Poor’s 500, avoiding the heavy stock-picking costs incurred by managed funds.

Many studies have shown that few managed funds can find enough hot investments to overcome this cost difference, causing the average managed fund to perform more poorly than its indexed counterpart. There are other benefits, too. Because indexers fly on autopilot, you don’t have to worry about something happening to your fund manager.

The enormous growth of the fund industry, with legions of managers scrutinizing securities, has made it even harder for managers to find undiscovered gems, making it even tougher for them to compete with indexers.

Still, some managers do beat the market performance year after year. So why shouldn’t an investor just pick the managed funds with the best track records?

One reason is that there are so many managed funds — thousands upon thousands — that some managers are sure to beat the averages through sheer luck, like a coin flipper getting a string of heads even though odds favor half heads and half tails. In seems likely that some managers really are talented, but how can an investor tell them from the ones who are just lucky?

Doing so would require two things.

First, the investor would have to know enough about stock and bond picking to spot real talent. Few investors have that skill. Nor do many have the time it would take to assess all the trades a fund manager made over the years. If the manager worked full time, as they do, the investor would have to work full time to keep abreast. And many funds use teams of managers ... Well, you get the picture.

Second, the investor would need insight into every trade the manager made, including the manager’s rationale, to distinguish the lucky trades from the skilled ones. But that information isn’t available. Funds report their holdings every quarter, but that’s only a snapshot of assets held on the reporting date. What was bought and sold between those dates is not reported.

So although there may be some splendid managers, no one knows for sure which ones they are. Millions of investors have concluded it’s too much trouble to try to find out, with slim odds of success.

With indexed funds, you settle for the market’s performance and need not worry that your “star” fund manager may not be a genius after all — or that he’ll lose his touch, quit, retire or fall under a bus.

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