If Your Goal is Wealth Maximization, You Can't Justify Active Management Over Indexed Funds
NY Times (Feb. 21, 2009) -- There's yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.
That is the finding of a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. The study measured the long-term impact of all expenses involved in investing in a mutual or hedge fund including transaction costs, taxes, and management and performance fees.
Mr. Kritzman calculates that just to break even with an index fund, net of all expenses, an actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.
The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.
But even that sobering statistic paints too rosy a picture, the professor said. That’s because it’s one thing to learn, after the fact, that a fund has done that well, and quite another to identify it in advance. Indeed, he said, he has found from his research that only a minority of funds that beat the market in a given year can outperform it the next year as well. “By definition, therefore, such a fund could not have been identified in advance,” he added.
The investment implication is clear, according to Mr. Kritzman. “It is very hard, if not impossible,” he wrote in his study, “to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And he said that those who still insist on an actively managed fund are almost certainly “deluding themselves.”