We couldn't agree more with Warren Buffett about the wisdom of using index-based funds for most institutional and individual investors. For our investors we focus on strategic asset allocation and use index-based funds and exchange traded funds (ETF's) to get exposure to each asset class. Most investors and advisors use "actively managed" funds where a portfolio manager attempts to beat the index by picking stocks, industry sectors, and timing the market. Unfortunately the vast majority of these actively managed funds over time lag the index they are trying to beat, sometimes badly. Why do most investors continue to bet on them? It is the triumph of hope, greed, and massive mutual fund industry advertising over reason. It is also because they are not aware of the poor track record of active funds relative to the indices they are trying to beat. Standard and Poors updates its study comparing the performance of active mutual funds relative to the index funds they are trying to beat over rolling 5-year periods. It is available on their website. The financial services industry does not want you to see this data. The industry makes much more money on expensive actively managed funds than on low-cost index funds.

This Standard and Poors study is a very powerful set of data in favor of index-based investing, and against active funds. For domestic stocks funds about one-third of active funds beat the index, among international funds less than 15% of the active funds beat the index, and among several classes of bond funds less than 20% of the active funds beat the index. This data is generous to the active funds because it only shows the 5-year record. Over longer periods of time even fewer active funds are able to keep up with the index. It is also being generous because this data is tracking pre-tax returns. Due to their higher turnover active funds are much less tax efficient than index funds. The percentage of active funds that are able to beat the index on an after-tax basis is considerably lower than shown here. Some people say that the large-cap U.S. markets are very efficient and so this data is not surprising, but that small-caps and international/emerging markets are less efficient and therefore there is more opportunity for good active managers. This data refutes that as well.

Tricks of the Trade at the Mutual Fund Companies

The industry has several tricks to make it seem like their active fund performance seem better.
1. Merge or close funds with poor performance. They regularly take funds with lousy records and close them down or merge them into a fund with a good track record. This wipes out the bad fund's track record or magically transforms it into a good record by merging it. This creates what is called "survivorship bias" in the numbers. The Standard and Poors data above corrects for this bias.
2. Advertise only the funds with good recent performance. It seems like all you ever hear about is the great funds all these companies have, since those are the only ones they talk about.
3. Only talk in terms of pretax returns. With high turnover the after-tax returns of their active funds are typically much worse.

Advantages of index-based funds (relative to active funds)

1. Much lower costs. We build diversified portfolios for our clients across multiple asset classes where the funds we use have an average expense ratio of only.2%-.3%. The typical active equity mutual fund has an expense ratio of around 1.2%. Many active funds also have up-front sales loads of as high as 5.75% (ouch!).
2. Lower turnover. Many active funds have high turnover ratios as the portfolio manager makes numerous trades trying to beat the market. This results in higher transaction costs.
3. More tax efficient. Index-based funds and ETF's are significantly more tax efficient that active funds due to their lower turnover ratios.
4. More transparent. You always know what you own in an index fund. With active funds you aren't sure what kinds of individual stock bets, industry bets, or other bets they are making.
5. More diversified. Index-based funds tend to have many more individual securities in the fund.
6. No style drift. Active funds often drift away from the size/style they are supposed to use in an attempt to chase better performance in other areas. When you are building a portfolio based on asset allocation (like we do) you want each asset class to actually represent that asset class, and not to try to sneak into other areas in an attempt to chase short-term performance.
7. More consistent performance. With active funds you have "relative performance risk" that you don't have to worry about with an index-based fund. Active funds often lag several percentage points (or worse) behind the index when their active bets go bad.
8. Better performance. See the data on the Standard and Poors study.

What if I only invest in the good 5-star active funds with great performance?

Unfortunately past fund performance in funds is not predictive of future performance. Numerous studies have shown this to be true. Others point out that it would take decades to statistically prove that a manager's good track record was due to skill and not luck. Many studies have shown that even the Morningstar famous star rating system fails to provide any significant predictive value for future performance. In fact a strategy of always buying the funds with the best recent 3-5 year performance is often a horrible strategy because it ends up causing you to chase good recent (past) returns, which can quickly turn in to bad performance as most strategies and styles "revert to the mean" over time. Are the portfolio manager(s) on the fund still the exact same now as when the past track record was created? Is the fund still the same size as it was when the track record was created (it's much more difficult with a larger fund)? The single best predictor of future performance is the fund's expense ratio (lower is better).