Index funds have been around for decades, but it’s only in the past several years that investing in passively managed funds has really taken off. Investors looking to take advantage of low-cost, broadly diversified portfolios have poured billions of dollars into index mutual funds and ETFs, mostly at the expense of actively managed funds.
But low fees aren’t the only reason to consider index funds. In this article, we’ll examine the five biggest reasons why investors should take a look at passive funds.
It Comes Down to Fees
Low costs aren’t the only reason to be invested in index funds, but they’re certainly the biggest.
In 2016, the average actively managed equity mutual fund had an expense ratio of 0.82%, according to the ICI. The average index fund charged a scant 0.09%. Why is that important? Expenses eat directly into investor returns. Even though it doesn’t seem like a big difference, it adds up over time. For example, an investor who makes a $10,000 investment in the Vanguard Index 500 Fund (VFIAX) Admiral share class and its 0.04% expense ratio would pay just $4 annually for a portfolio of 500 of the largest companies in the United States. Investors could spend hundreds of dollars trying to build a portfolio like that on their own.
Check our take on why it is becoming extremely difficult for active managers to beat the market.
The Markets Are Really Efficient
The bread and butter of any financial advisor is the ability to find winners in the vast ocean of equities. As trading volume in the markets increases and the number of traders with online brokerage accounts grows, the number of opportunities to exploit winners shrinks and the window to take advantage becomes smaller. Study after study shows that even professional money managers have a difficult time beating the market, with more than 90% failing to beat their benchmark over the past 15 years. As a result, several investors are opting to simply match the benchmark, and are doing so at a much lower cost.
The proliferation of online brokerages has brought the cost of trading way down. Even considering that, it can still be costly for individuals, especially those with more limited means, to construct a diversified portfolio. For these folks, passively managed funds are ideal. They provide broad diversification in almost any market, sector or region for an incredibly low fee. Diversified portfolios help smooth out the volatility in the markets as different segments fall in and out of favor, and that can help limit downside risk, especially during turbulent markets.
Information is Everywhere
The internet has made the availability of information worldwide almost instantaneous. Whereas “instant” information in the past was limited to those with access to it, virtually everybody today knows what is happening in real time. That means that even small investors are aware of the value proposition of an investment quickly. Active managers had more opportunity to take advantage of these situations in the past, allowing more of them to outperform the markets. This is exactly why so many active managers are forced to at least consider adopting a more passive strategy.
Check here to learn if it will be easier for active managers to outperform the market as investors avoid active funds.
Active Funds Don’t Provide Downside Protection
Many investors prefer actively managed funds because they believe the manager will simply rotate out of the market when it declines, thus protecting them from market downturns. There are two problems with this thinking. First, this notion assumes that the active manager will be able to both recognize and get out in front of a prolonged downturn. With very few managers able to outperform their benchmarks over time, it’s reasonable to assume they won’t have any consistent success identifying bear markets before they happen. Second, even if they were able to identify downturns ahead of time, many actively managed funds don’t attempt to time the market.
The Bottom Line
Many investors are realizing that paying above-average fees for market underperformance doesn’t make sense. The advantages of low-cost strategies that give investors the ability to build complete portfolios easily are resulting in a sea change in the way individuals invest their money. The benefits of these strategies are finally putting control back in the hands of the average investor.
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