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Passive Investments or Managed Portfolios?

George Chamberlin | 4/14/2015 04:02 p.m.
It has long been suggested that passive investments – the use of index mutual funds without the need for expensive professional management – outperform actively managed portfolios. And a new report confirms that passive significantly beats active.

It has long been suggested that passive investments – the use of index mutual funds without the need for expensive professional management – outperform actively managed portfolios. And a new report confirms that passive significantly beats active. In fact, the numbers are quite striking. According to S&P Dow Jones Indices, 86.44 percent of large-cap fund managers underperformed the benchmark (the S&P 500 stock index) over a one-year period in 2014.

The poor performance in 2014 was not a one-off event. The same report shows that over the past five years, 88.65 percent of managed mutual funds underperformed the S&P 500 stock index. Unfortunately, actively managed mutual funds start with several disadvantages before they even invest their first penny. In order to have enough money available to pay investors who may wish to sell their shares, many managed funds carry large cash balances, often as much as 20 percent, leaving them able to invest only 80 cents on the dollar.

The long-term impact of higher fees on managed mutual fund stock portfolios has a serious compounding effect. A study by Vanguard Investments showed that $100,000 invested in an actively managed mutual fund with an annual expense rate of 0.9 percent and growing at an annual rate of 6 percent will appreciate to $438,976 over a 30-year period. However, if the annual expense rate is just 0.25 percent, typical for a passive portfolio, the investment will grow to $532,899 in the same period of time.

The advantage of passive investing is not ignored by Warren Buffett, perhaps the most successful long-term investor. In his annual letter to Berkshire Hathaway shareholders in 2013, Buffett said, “Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So, ignore the chatter, keep your costs minimal…

Buffett went on to say he has instructed his personal trust, which will distribute assets to certain friends and family members, include the following investment advice, “Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

This strategy, after many years of paying high fees to managers, is now being followed by a growing number of large pension funds. Pennsylvania governor Tom Wolf, in his 2015 state budget proposal, is calling for pension investment reform to, “significantly reduce excessive management fees and our reliance on high-risk investment strategies.” The state paid out $600 million in fees to managers last year and Wolf is suggesting “Less costly passive investment approaches where appropriate.”

Bottom line – actively managed stock funds and accounts can, from time to time, provide greater gains after expenses. However, for most individual investors, keeping fees in check and investing for the long-term is a more appropriate approach.

Hear more from George Chamberlin in this short video.

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