[Please read my What is a fund and The Hidden Cost of Investing before reading this article, as they establish the basic concepts needed for understanding this post. Additionally, if you haven’t yet, please read the website disclosure statement.]
Active or Index Funds, How to Decide
So, you are in the market for a new fund. Whether it be a mutual fund or ETF, there are a plethora of choices. But, while tens of thousands of funds exist, you must decide on the age-old question: Do you go with an Active or Index fund?
Just as with anything in life, there are benefits and drawbacks to both. My goal for today’s post is to highlight these so you can make the most educated decision. When making the active or index choice, three crucial factors include a fund’s Future, Fees, and Family.
The three F’s, for short, help you evaluate a fund’s potential future performance potential, its cost to operate, and its shaping characteristics and influences. Of course, to some, other factors are merited. However, to me, these three are the most significant and thus meaningful. So, without further ado, let’s dive in!
The future performance of a fund derives from various influences; for me, two are of the most significance.
First and unequivocally, performance for all funds is shaped by the index followed. Secondly and selectively, past performance shapes the future for active funds.
Why is this? Suppose you invest in a short-term government treasuries fund. In this scenario, you should not expect to lose money, nor should you anticipate making much, either; this is because short-term treasury funds return meager gains for stability.
On the flip side, if you invest in a total market fund, you are much more likely to experience meaningful gains or losses, whether it be composed of stocks or bonds. These significant fluctuations stem from the fact that total market funds invest in assets that are not as stable in the pursuit of gains for their investors.
While a difficult way to predict the future, the index followed must not be overlooked. This is because indexes are the basis for what a fund will mimic or attempt to beat, and if a poor index is chosen, your growth potential will suffer.
Past performance shapes the future for active funds and requires research for those who go the active route. Why? Well, simply put, active funds tend to win, or they tend to lose; there isn’t much middle ground.
Furthermore, because you rely on the expertise of the active fund manager, who is trying to beat the market in exchange for more of your money, some managers must fail. Not everyone can win; statistically, it is not possible.
As a result, most active funds tend to lose, and those that consistently win tend to continue doing so. This performance trend stems from the fact that funds with a track record of outperforming have found an adaptable strategy that works to beat the market. On the other hand, those who consistently underperform their index fail to make the right moves regularly.
But Olaf, wouldn’t everyone invest in active funds if they found one that always won? Great question, but no.
Some people prefer index funds because they cost less. But, more importantly, no one can guarantee the future success of any active fund, period. An active fund with a long record of beating the market does not safeguard investors from future underperformance. Statistically, all active funds are bound to underperform eventually.
While this concept of no guarantee to future gains is the same for index funds, investors receive the index’s returns rather than worse performance at a minimum. With active funds, around 80% underperform their index each year! Thus, active funds are for those able to tolerate higher risk in pursuit of gambling on greater reward, but they will pay more and have no guarantee for this extra risk taken. If you are not a gambler, indexes are the best choice.
My suggestion for all investors is to choose a total market or broad-based index that gives you exposure to the level of stocks or bonds you are seeking. This is because total market and broad-based indexes help diversify your positions and thus increases the likelihood of not missing out on potential gains from a specific part of the market. In addition, they participate in all ups and all downs, tempering gains but moderating losses. Then, if you have decided to take more risk by choosing an active fund, you must study its past performance to ensure it is the right choice.
For riskier investors, place 80% of your money into index funds and allocate the remaining 20% into well-vetted active funds; this helps temper your chances of underperforming the market. If you do not like taking more risks for a gamble, then choose index funds only. If highly risk apt, you can consider more than 20% exposure to active funds, but you statistically are unlikely to benefit.
Remember, choose the index to follow first, and decide from there!
Easy to overlook, fees are a huge consideration that every investor must consider when using a fund. There are generally three layers of fees with funds, which I suggest you limit exposure to no more than one. These layers are Transaction, Load, and Expense Ratio fees, and I would challenge you to avoid ever paying transaction and load fees, as they are entirely avoidable.
Transaction fees are costs your investment Firm charges you for the privilege of purchasing a fund. These generally stem from the fact that the fund and the Firm do not have an established professional relationship, though it can vary.
With transaction fees, most large brokers nowadays offer plenty of choices to funds that are exempt from these charges. Further adding credence to this point, transaction fees are applied anytime you buy or sell a fund, whether the transaction is for $1 or $1,000,000; thus, they add up fast.
So, find a fund that follows the index you want and ensure it does not have transaction fees charged by your Firm, or if you are set on a broker, find funds that will not incur these pesky and outdated charges.
The next type of fee I avoid is what I call a deal-breaker, known as a load. A load is a cost to either buy in, continue to own, or sell a fund. Loads used to be the price of admission in the world of funds. They were used to advertise funds to investors through 12b-1 fees and pay salespeople for selling them through front-loaded fees.
With loads, for example, you go to buy $1,000 of a fund. Now, instead of receiving $1,000 of investments in that fund, you pay a commission of a particular one-time or reoccurring amount. So, in our example, instead of receiving $1,000 of assets, you receive $950 in ownership. The remaining $50 is lost and paid to the Firms involved in the transaction.
In the example above, you start at a loss of $50, from which you must dig out and recover. Many firms, advisors, and financial personalities will still tell you loads are good because they help you find the best fund for XYZ reason. I don’t see it this way, and you should not either, period. The easiest way to know if your fund has a load is to look if it’s labeled as Class A, B, or C or if it makes a note of a 12b-1 fee. If you are unsure, always ask your Firm. Nowadays, most loaded funds are active, but some index-loaded funds do exist, so be careful!
Lastly, when investing in funds, the expense ratio must be considered, which I previously wrote an entire article on, located here. To summarize, an expense ratio is the cost to run a fund, day in and day out. Index funds have lower expense ratios than active funds because they have fewer overhead costs. On the other hand, active funds do additional research and try to beat the index, often trading more frequently through the process, which drives costs up.
Generally, the lower the expense ratio, the better a fund will perform. With index funds, the expense ratio is of the utmost importance. With active funds, they do matter, but they are not as meaningfully significant as future performance due to the strategies they employ.
Fund family is a strange term to hear for the first time, but it refers to the different funds offered by a specific company to investors. For example, some fund families include Ark, T. Rowe Price, and Vanguard. Some Firms specialize solely in funds (like Ark). Others offer funds, investment accounts, and additional products (like T. Rowe Price and Vanguard).
The category of fund families is important because by being strategic in which family you choose, investors can generally reduce fees and increase future performance potential. This stems from the fact that more prominent and successful fund families are better able to distribute costs and share research, meaning they can reduce fees and gain a competitive edge over their peers. Additionally, Firms that offer products such as accounts, loads and transaction fees are typically waived. So, use fund families as a way to bolster your top choices when choosing a fund.
As I have shown, many factors must be considered when choosing a fund, whether it be Active or Indexed. Always remember to ensure you select the most appropriate index, avoid transaction fees and loads while keeping your expense ratio modest, and choose a well-respected fund family.
If you want the highest chance to make money while not take on undue risk, choose a variety of low expense, total market index funds that offer domestic and foreign stock exposure, plus add in some bond funds.
On the other hand, if you like to gamble for a possibly greater return, consider investing around 20% of your portfolio in active funds and ensure that they have a good track record for that fund and family.
Regardless, use this post as a tool in your decision-making process and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time