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Some Sage Advice from the Guardian

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The title of this Guardian article by Kira Brecht (“How Highly Paid Wall Street Guys Could Be a Threat to Your Retirement Money”) perfectly summarizes the situation of today’s individual investors. Brecht begins with the decision of Washington DC entrepreneur Rasheen Carbin to dump his actively managed funds in favor of a combination of Vanguard index funds. Brecht notes that in 2014, 80% of equity mutual funds lagged the widely followed S&P 500 Index. Morningstar’s director of research John Rekenthaler declared 2014 to be a “terrible year for active managers.” Mr. Carbin hit the nail on the head when he said, “I’m switching to investing exclusively in index funds. The vast majority of active managers can’t beat the market. I see no reason to go on paying high fees for underperformance.”

Brecht cites Morningstar data showing that passive funds had inflows of $131 billion in 2014 while actively managed funds suffered outflows of $90 billion. Morningstar’s Rekenthaler predicts that within five years, actively managed equity funds will have a lower level of assets than passively managed funds (which currently account for 35% of assets).

The primary impediment to the performance of actively managed funds is their higher costs. For large cap blend funds, the Morningstar average category expense ratio is 1.14%, which is more than a full percentage point higher than the cost of an S&P 500 Index fund either as a mutual fund or an exchange-traded fund. Brecht is absolutely correct when she says that fees can consume up to one-third of investment gains over the long term.

The answer to the question of why more people have not switched from active to passive can be found in the Lake Wobegon effect as it applies to investing. You may recall that Lake Wobegon is the fictional Minnesota town where all the children are above average. There is still a persistent idea that to index is to settle for average which is anathema to our belief that we deserve better than average in our investments. The irony of it is that through indexing, investors do have the ability to be above average simply by avoiding the higher costs of active management. As for the few active funds that have delivered outperformance of their benchmarks (Brecht provides the Glenmeade Large Cap Growth fund as an example), a deeper look will often reveal that the higher returns came from risks taken that happened to work out in favor of the fund. In the case of the Glenmeade fund, the outperformance resulted from “significantly more exposure to the technology sector than the S&P 500 and significantly less exposure to financial companies.”

At Index Fund Advisors, we hope to see many more articles like this one, and we will continue to do all that we can to encourage the shift from active to passive.