Passive Index Funds Beat Active Funds

Financial Disinformation: Set Up Your BS Detector for Success

finance in the news Jul 15, 2024

Last week Yahoo! Finance reported on a pretty wild on-air exchange from The Ramsey Show hosted by Dave Ramsey. In it, a 21-year-old caller questioned why Ramsey's team promoted investing in mutual funds instead of index funds. This led to an extended debate with the show's co-host, George Kamel, a Ramsey Personality, and self-styled "personal finance expert."

 

Getting the Terminology Right

Firstly, let's set things straight: index funds are mutual funds. Mutual funds are large portfolios that invest in lots of stocks. The reason they're called a "fund" is that the money used to buy those stocks comes from a specific pot of money: the SEC (Securities and Exchange Commission) has rules about how a person or company can pool together money, so "fund" is a real, technical, legal term. They are called "mutual" because thousands of people contribute money to the fund, and then get a share of the investment gains according to how much of the fund they bought.

What the caller meant to ask was, "why invest in actively managed mutual funds instead of passive index funds?" A passive index fund uses the money pooled by its investors (shareholders) to buy all the stocks available for the strategy. For example, an S&P 500 Index Fund invests in the S&P 500 which is a list of -- you guessed -- 500 companies; you will own shares of 500 companies pooled together in your one share of your index fund. Because there's no guessing or selection of stocks, it is called "passive" because there isn't much work to do. Most of these funds are managed by bots. As a result, you pay very low fees on your investment, usually less than 0.1%, sometimes as little as 0.01%!

On the other hand, an actively managed mutual fund has a Fund Manager who looks at the S&P 500 and picks stocks they like while passing on those they don't. They're putting in time and effort to research and select (guess) what they think will be a better investment. For example, they might buy extra shares of Coca-Cola and sell shares of NVIDEA if they believe a recession is coming. For all that time and work they put in, they need to get paid, and they get paid in the form of higher fees. The average expense ratio for these funds is 0.65%, and can be as high as 1.5% or more!

 

Investing Implications

What does that mean for you as an investor? Simply put, if you choose an actively managed fund, you've got to do better than the market. Passive index funds don't have to do much to match the "index", for example the S&P 500, and almost all of them do. In fact, only 17% of passive index mutual funds fail to beat the benchmark -- after fees are paid. Almost 100% match, and 83% actually do better than the index, enough so that the extra profits are more than enough to pay for your fees.

On the other hand, actively managed funds do worse compared to not just the index, but even compared to passive funds. One reason is stock price moves are random, so the Fund Manager is generally just guessing. Another is that you have more expensive fees. In order to make the same Return on Investment (ROI) for money you invest with an active fund, that Fund Manager will need to get at least an extra .55% returns just to pay for the additional fees and break even.

Over the ten years of 2014-2023, the rate at which active funds did better than the index (or passive index funds) was just 12% for large cap, 25% for mid-cap, and 32% for small-cap. That means that if you chose to invest with passive index funds over ten years you'd have an 83% chance at beating the market, while if you chose active funds you'd have an 88% chance at doing worse.

 

Lies, Damn Lies, and Statistics

This is the point at which this episode of The Ramsey Show became a total joke: George Kamel at one point argues you should invest in actively managed mutual funds because, "Morningstar reported that nearly 57% of actively managed U.S. equity funds beat the average index fund peer over the 12 months through June 2023. So, six out of 10 mutual funds beat the index."

Not only did George Kamel not read the report, Dave Ramsey must not have either. If he had, he would have stopped the show immediately and told Mr. Kamel to turn off his microphone: that statement is entirely false, and mixes up facts and categories to tell a what amounts to a fantasy story.

But guess who has read the Morningstar report? I have.

Only two categories of actively managed investment funds had a 57% success rate "over the 12 months through June 2023": US Small Blend and Aggregate Bond Index funds. U.S. Large Growth category funds had a 53% success rate -- but every other category of "U.S. equity funds" did worse than 50%. That means you're better off flipping a coin than investing in an actively managed fund.

Moreover, beating the "index" is different than beating "index funds." 57% of Small Blend U.S. Equity Funds and Aggregate Bond Funds did indeed beat their indexes, BUT in the U.S. Small Blend category for that time the passive index fund options still beat the actively managed funds. Moreover, that 57% success rate dropped to just 43% by December -- also in the report (on the very next line, in fact).

 

In Data there is Truth

The point of investing in mutual funds isn't to do better in one year, it's to do better over the long-term, so we're talking at least 5 years. If you have financial goals within 5 years, don't expose your savings to market risk, and instead save in a High Yield Savings Account. Use your brokerage account to invest in mutual funds for goals more than 5 years away. And when it comes to measuring performance, use the 10-year performance returns to judge if the mutual fund you want to buy is any good. Historically U.S. equity markets have cycled between Bear (down) and Bull (up) markets about every six years or so, so using a 10-year performance return generally tells you how that fund will do in all types of conditions.

From this same Morningstar report (Morningstar’s US Active/Passive Barometer: Year-End 2023), we learn the following about the comparative returns, after fees are paid, of active and passive funds:

  • Across all categories of actively-managed funds, fewer than 1 in 4 beat the passive index fund option over the ten years from 2014-2023
  • In 19 out of 20 categories, the passive index funds outperformed the actively managed fund
  • U.S. equity passive index funds beat active funds by an average of 0.9% per year 

This really matters to you and your future wealth. In the U.S. Large Blend category, which is kind of like your standard S&P 500 fund (or the TSP's C-Fund), the average 10-year return for actively managed funds through 2023 was 10.4% per year, while passive index funds average 11.7%. Remember, this is after fees, so in this one category that happens to be the easiest and most accessible the passive index fund option yields 1.3% more per year on average in the long run.

How much does it matter? Let's assume you have $10,000 in your brokerage account now, and you have an annual goal to invest $10,000 in the same fund. You can choose the passive or active strategy, and will get either 10.4% or 11.7% returns. Your results will be:

  • After 10 years, the active fund would reach $204,279.04
  • After 10 years, the passive fund would be worth $222,155.99
  • After 20 years, the active fund would reach $751,479.20
  • After 20 years, the passive fund would be worth $901,858.27

We're talking about a big enough difference to buy a new car, or make a down payment on your dream home. These are not small differences. In fact if we're talking about your retirement savings, after 30 years the difference expands to $2.3 million versus $3.1 million. That's an extra $800,000!

 

Setting the Record Straight

The Ramsey Show has a huge following, and the brand is valuable. Dave Ramsey's programs for getting out of debt are great, and saved many lives. But when it comes to investment advice, be careful what you listen to, and believe. There is truth out there, and there's a reason why those in the financial world who are either licensed "fiduciaries" (meaning they have to treat your money like their own and maximize your return, even if it means you don't buy their products) or promoters of Financial Freedom are so passionate about investing in passive index funds. They simply earn better returns.

Whenever you hear someone arguing that actively managed funds are a better investment, you are probably listening to someone who is trying to sell you their own products. They may be Fund Managers -- or they may be professional Financial Advisors, Wealth Managers, Retirement Planners, or other industry professionals. Those folks have friends who are Fund Managers, and they all get a slice of the "fee pie" they earn if they can sell you their actively managed funds. Don't buy them.

The good news is that all of this data is available online -- much of it for free. It cost me my email (and checking an "opt-out" box) on a form to get the free Morningstar report. Before you follow some radio personality or flashy brand's advice on how to invest, do your own research. Future You will have $100,000s more wealth, and will thank you.

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