Proof Active Funds Are a Waste, All in One Place

NEW YORK ( AdviceIQ) -- Some high-flying mutual fund managers promise outsized returns in exchange for their wisdom. Many investors are happy to pay handsomely to beat the market. Unfortunately, a lot of these top-notch funds don't. Look at the data before buying into one of them.

A better idea: passively managed index funds that track benchmarks like the Standard & Poor's 500. Fees for funds like these are much lower than for actively managed investments, which try to outpace an index by investing in the securities the manager believes will touch the stars. Active funds charge around 1.4% of asset yearly, while indexes ones go for 0.1% or so.

You might think, "Why would I limit myself to just average gains by buying an index fund when I could pick a manager who has a chance of beating it?" Before you buy, look at the supposedly stellar fund's performance.

One great way to compare active and passive funds is the S&P Indices Versus Active Funds Scorecard (SPIVA) . The SPIVA report compares all actively managed funds against their respective benchmarks. It is compiled by Standard & Poor's at the middle and end of each year.

The SPIVA report is especially informative because it accounts for survivorship bias. This bias is a distorting calculation that fails to count active mutual funds with poor performance records that are closed or merged into other funds. With the poor track records of these defunct funds overlooked, the performance of the remaining active funds looks better than it otherwise would. By including the performance records of closed funds, the SPIVA report provides a better comparison of the performance of active managers against their benchmarks.

Percentage of active funds underperforming benchmark (2002-2011, SPIVA data)

All large-cap funds: 59.4%

All mid-cap funds: 63.5%

All small-cap funds: 63.1%

These are big shortfalls: Over the past 10 years, an average of 59.4% of large-cap funds, 63.5% of mid-cap ones and 63.1% of small-cap vehicles failed to beat their respective benchmark. The odds of picking a winning fund were low even in the small- and mid-cap arena, where many people assume that active managers have an edge since these stocks aren't as heavily researched as large-cap stocks.

Some investors argue that an active fund can outperform during a bear market since the manager can move to cash. Index funds, on the other hand, have to remain fully invested even when the market declines.

The SPIVA report showed that active funds didn't perform as well as many expected during the last two market downturns. When looking at all active large, mid and small-cap funds, the report found that anywhere from 54.3% to 83.8% were outperformed by their respective index during the 2000-2002 and 2008 bear markets.

Percentage of active funds underperforming benchmark ('00-'02 bear market, SPIVA data)

All large-cap funds: 53.5%

All mid-cap funds: 77.3%

All small-cap funds: 71.6%

Percentage of active funds underperforming benchmark ('08 bear market, SPIVA data)

All large-cap funds: 54.3%

All mid-cap funds: 74.7%

All small-cap funds: 83.8%

I've read SPIVA reports for years, and the results are fairly consistent. Although considered boring by many and often ridiculed by investment pros, index funds are one of the best investment vehicles for individual investors. In fact, institutional investors have used index-type investments for years. In most cases, you would usually be better off just choosing an index fund.

This underscores the importance of looking for impartial information on a fund before you buy into it. Of course, due diligence still doesn't guarantee that you won't get burned. Even if a fund can honestly boast index-smashing performance, that won't necessarily continue after you invest. Even mutual fund giants like Legg Mason's Bill Miller, whose fund beat the S&P 500 for over a decade, and plenty of star hedge fund managers like John Paulson, have having some bad years lately.

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--By Neil Vannoy, president of Vannoy Advisory Group , a fee-only financial planning firm with offices in Round Rock, San Antonio and Waco, Texas, for AdviceIQ

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