Index Funds, Actively Managed Funds, or Individual Stocks?
Any finance professional will tell you that if you want to grow your wealth, your asset allocation needs to include stocks. The reason is simple – stocks have the highest potential return. In the many articles on how to invest for your retirement, a common recommendation is to get stock market exposure through a low-cost index fund. There are good reasons for that, but buying actively managed funds or individual stocks are also valid approaches, with different benefits and drawbacks. I want to discuss some of those here. I’m not a financial advisor, but this is my take based on what I’ve read and my own investing experience.
Before we get into that, I should point out that we’re only talking about the stock portion of a portfolio here. The concept of asset allocation – how much to invest in stocks versus bonds versus anything else – is a topic for another article. Similarly, I’m ignoring targeted maturity funds, since they take care of asset allocation for you. I’m also ignoring exchange-traded funds (ETFs), which can be a good alternative to index funds.
Index funds have a lot going for them. First, since they don’t have to do a lot of research to determine what stocks to put in the fund, they typically have the lowest expense ratios (the amount you pay to own the fund). The low turnover of index funds makes them tax-efficient, so they can be good choices for taxable accounts. Index funds are also basically guaranteed not to under-perform the market. Morningstar found that 75% of actively managed large-blend funds failed to match the returns of the S&P 500 index, so knowing that your fund won’t under-perform brings some peace of mind. This also means you don’t have to do a lot of research into different funds, because all the funds that track a particular index will be very similar. And of course, buying any fund has the benefit of built-in diversification – you’re not overly exposed to a meltdown of any single company. All these factors combine to make index funds about as close as you can get to fool-proof investing.
Index funds do have one disadvantage, though. You’ll never beat the market with an index fund. Following an index can be risky when that index becomes overvalued. When a bubble develops, you’re buying into that bubble, and you’ll suffer the ensuing bear market when the bubble bursts.
That brings us to actively managed funds. The big advantage of such funds is that they can beat the market, which becomes especially important in a bear market. Look at Fairholme (FAIRX) for an example of how a good actively managed fund protects you from the bear. When the tech bubble burst, the S&P 500 lost 9% in 2000, nearly 12% in 2001, and a full 22% in 2002. Fairholme only lost money one year, in 2002 – a mere 1.6%. While index investors watched over a quarter of their money evaporate, investors in this fund actually made money. And with actively managed funds you still get the built-in diversification.
The problem? Most funds don’t perform as well as Fairholme has over the long term. As mentioned above, a full 75% can’t even match index returns, much less beat them. This means investing in actively managed funds takes a lot more research. You have to look for good managers, and examine how the fund and the management team has performed, especially during bear markets. Even when you find a good fund, it won’t necessarily perform as well in the next bear market as it did in the last. You also have to watch the fund for changes – your research time doesn’t end when you decide to invest in the fund. If new managers take over, the fund you originally chose might not be a good investment any more. The investment style of a fund might also change, putting it out of sync with the rest of your portfolio or your risk tolerance. Actively managed funds carry higher fees than their index counterparts, and some of them can have high turnover, generating lots of taxable income. If you’re not careful, it’s very easy to end up investing in a fund that lags its index while costing you more money.
The ultimate low-cost option is, of course, buying individual stocks. You’ll pay brokerage commissions to buy and sell, but there is no management team taking a small part of your assets every year. Assuming you use a buy-and-hold strategy, you can usually more than make up for the brokerage commissions by avoiding fund expenses. Buying your own stocks also gives you total control over your capital gains – no need to worry that your fund manager is going to dump a big taxable gain on you.
The big downside to stocks is the amount of research time you have to put in. First, you’ll need to choose about 20 stocks to be properly diversified, assuming an equally-weighted portfolio – that means lots of research time right up front. Then you’ll need to keep a close eye on your choices, watching for changes in management, financial health, competition, as well as the stock price so you know when it’s time to sell. You may also need to watch other stocks, keeping an eye out for bargains so you can buy in at a good price point. If you want exposure to foreign stocks and small caps, expect to spend even more time on research, since it is much harder to get good information on these types of companies. Stocks also have high individual volatility, so it can take an iron will to ignore the daily noise of the financial press and stick to your convictions. If you’re investing small amounts of money on a regular basis, those brokerage commissions can really add up. And it’s entirely possible your return won’t keep up with the index, just like most managed funds.
So, what is the best choice? I think it comes down to how much time and effort you want to spend dealing with your investments. Index funds take almost no time or effort and automatically get you market-matching returns, so they are probably the best option for most people. Personally I tend to go with actively managed funds. It takes more research, but a good one can help you avoid the perils of a risky bubble – while a bad one just makes you pay for worse returns than the index. I have a friend who loves avoiding fund fees and capital gains by going the individual stock route. Stocks take the most research and carry the most risk individually, but if you diversify appropriately you can get the benefits of a fund without the extra cost.
And no, at the time of this writing, I didn’t own any shares of FAIRX… though it’s definitely on my list of potential future investments.
Sorry, but this line of thinking does not make any sense to me. You mention that 75% of actively managed funds underperform the index (depending where you look, the figures are from ~60 to ~80%). Also note, that does not mean that the other 25% outperform the index. Maybe 5% or less actually do outperform the index (again depending on how far back you would look).
Therefore, your suggestion that someone can do their own stock picking to achieve the best results means that someone would need to beat top five percent of the financial gurus out there. Good luck with that.
Same goes with selecting an actively managed fund – you are basically saying that you are able to determine who the top 5% of financial gurus are AT ANY GIVEN TIME. Like you said yourself, these will constantly change, so just like the stocks, you would need to pick the “right” ones consistently. Good luck with that.
Finally, the only argument you provide against index funds is the possibility that they would inflate as the market starts chasing another bubble. However, this is exactly what asset allocation is for. As soon as the index starts to balloon in your portfolio, you sell some of it to maintain your target allocation.
Dima
Thanks for the comment, Dima. First of all, your point about asset allocation is correct. But as I mentioned, I’m ignoring asset allocation for the purposes of this article.
Regarding actively managed funds, the top fund managers don’t constantly change, unless you’re focusing (wrongly) on short-term returns. My point was that when it comes to active funds, you’re investing in managers – and if management changes you should reconsider the fund. You should follow the manager, not the fund, because there are managers who are able to beat the market repeatedly for long periods of time. For example, one study (http://goizueta.emory.edu/faculty/KlaasBaks/Documents/baks_metrick_wachter_000.pdf) used Bayesian analysis to prove this point.
For individual stocks, don’t underestimate the power of having no expense ratio and no capital gains. That gives you a huge advantage over actively managed funds and makes it much easier to get index-matching returns. You don’t need to beat the top 5%, or even the top 25%, to get index-matching returns with your own stocks, specifically because you’re not hobbled by having 1% or more sliced right off the top of your return. I may revisit this point in a future article if I can dig up some good data.
Bill: Thanks for this article. Let me ask a couple of questions:
1. Is an Index Fund really just one type of Mutual Fund?
I really don’t know the answer. My broker has me in mutual funds, but I have no idea the specifics (it’s all there on the statement but I just look at the gain each month and rarely anything else).
2. Do you use a broker or do you just buy these through an online brokerage account like Schwab or ETrade?
Your article makes me think because for the most part on all three topics: Index Funds, Actively Managed Funds, or Individual Stocks – I’ve taken the approach of “I don’t know and I don’t care”. I’ve never researched the funds that my broker has put me in. It’s just not interesting to me or worth my time – isn’t that her job?
My attitude is why I’ve never attempted buying stocks on my own and probably why I’ve allocated a portion of my portfolio to real estate. I search and buy rental properties with the same enthusiasm that you have with the market. I’ve just never put any emphasis on learning.
Funny, but one of our financial goals this year was to open an ETrade account by starting small. We’ve yet to do this and it’s November. I guess that goal will be on the rollover list for 2008. Losing ten pounds is in the same category. Oh well.
Any suggestions? Not on my weight loss, but on dipping my toe in the market without my broker.
1. You have two basic management styles for funds: active or passive. Active management means picking stocks in an attempt to beat the market. Passive management means you just mirror an index. That’s what defines an index fund – passive management. Now, even within index funds, you have a huge variety of choices because of the variety of indexes. You have funds for the S&P 500, Russell 1000, MSCI U.S. Broad Market Index, Dow Jones Wilshire 5000 Index, and many others, and that’s just for stock funds – there are also bond funds that track bond indexes. So, once you decide to go with index funds to save on fund expenses and get guaranteed market-matching returns, your job isn’t done yet. You still need to build a portfolio based on your goals. That could be as simple as buying one broad-index stock fund and one bond fund, or as complicated as you want to make it, including foreign indexes, small-cap indexes, and others.
2. To answer this question, you need to understand a little more about fund fees. In short, some funds carry a 12b-1 fee, which is basically a commission paid to the seller of a fund. This fee is built into the overall expense ratio that you pay to own the fund. Funds with 12b-1 fees can usually be bought through a broker, including online brokers, with no special fee charged to you, because the broker is already getting paid through the 12b-1 fee which is built in to the fund. For funds that do not carry a 12b-1 fee, you typically have to pay some amount in order to buy through a broker, just like you do with stocks. Those fees can be avoided entirely, however, if you just go straight to the fund company. For instance, if I was going to go the index route, I would probably just open up an account with Vanguard (generally regarded as the low-cost leader in index funds) and buy fund shares directly from them, skipping the broker entirely. If you’re buying funds from many different companies, or some have 12b-1 fees and some don’t, it might make sense to use an online brokerage or a regular broker just so you can conveniently manage everything in one place. Just be aware of the fees your broker is charging so you can minimize them.
Given your lack of interest in stocks, if you were going to manage your own investments, indexing would be the clear choice. Since you’re going through a broker, hopefully the money you’re paying the broker is generating market-beating (or at least market-matching, after you subtract the costs) returns. If you’re that interested in real estate, then you probably are much better at real estate investing than the average person and can get better returns from that anyway. You’re using stocks to diversify away some of your risk in the real estate market, which is perfectly valid.
Before you do anything on E*Trade, I recommend you go straight to Morningstar’s Investing Classroom and click on the Stocks Curriculum: http://www.morningstar.com/Cover/Classroom.html. That’s the best introduction to stock investing that I’ve found online. Once you’ve done that, you’ll be very well-prepared to start that E*Trade account. Experimenting with the stock market can be very educational, but if you really don’t enjoy it, I’d stick with indexing or using a broker for your stocks, and put your own time and energy into what you know and love – real estate.