Actively Traded Versus Index Funds

Looking to Beat the Market with a Mutual Fund

When it comes to measuring mutual fund performance, the benchmark that is most often used is the performance of the S&P 500. The S&P 500 is a broad based index of U.S. stocks, which many investment vehicles track, and this is more than just a measurement of one’s success, it also has practical implications.

Since a mutual fund can simply track the S&P 500 or any other index by simply replicating the index with their funds, in this case, by having a position in the component stocks such that the performance of the fund will simply mirror the performance of the index, if it turns out that alternative strategies underperform the performance of the index, the index instead could have been tracked and we would have had a better result.

Actively Traded Versus Index FundsNot all mutual funds take a global approach to investing, and many focus on particular sectors of stocks. While we can use other benchmarks to measure their performance, an index of the sector for instance, it still would be the case that if the basket of stocks held in the mutual fund underperforms the broader market, the fund could still have sought to replicate the index and achieved the better performance.

While there may be other reasons to focus on a specific sector, for instance to look to satisfy the demand for people wanting to purchase funds within a sector, sector funds are less diversified by nature and also tend to be associated with more risk generally, so if a fund is going to focus on a sector, it’s important that the sector outperform the market as a whole.

This is not always the case though and we always need to be aware of opportunity costs, and when it comes to mutual funds, we must always assess the opportunity costs of just going with replicating an index, which include both the index of the sector and broader market indexes such as the S&P 500.

How Well Do Mutual Funds Do in Beating The Market?

With all of the effort and resources that mutual funds and their managers put into beating the market, we might assume that they usually accomplish this, or at least beat the market more often than not. Given that people are paying for this additional management and oversight, by way of higher management costs, they will of course want to get their money’s worth out of this by way of better returns, and meaningful better returns.

As it turns out, quite surprisingly perhaps, only about 20% of funds beat the market over time, meaning that about 80% do not. We don’t want to say that therefore this is an exercise in futility, as the 1 in 5 funds that do beat the market may well be worth considering, and performance of mutual funds over time is very well documented and widely available.

Just because a mutual fund has beaten the market over the last few years though doesn’t mean that this will continue. There is a certain amount of luck involved in investing and the good performance may have just been a matter of that.

Funds which consistently underperform the market though would at least be statistically less likely to do so in the future, so it’s not that past performance data does not matter. On the contrary, if one wishes to pay premium management fees to shoot for the better returns that actively managed funds promise, then it certainly pays to do your homework and look to assess the likelihood of this actually happening.

Given that most funds do not succeed in accomplishing this feat though, extra diligence must be used in order to look to separate the wheat from the chaff so to speak, and it’s mostly chaff so you have to work even harder than if most funds performed well and only a smaller percentage needed to be excluded.

How Many Mutual Funds Miss the Mark

Why so many mutual funds fail to achieve their objective of basically beating what amounts to a random basket of stocks has been well studied, and as it turns out, when it comes to stock selection, it turns out more is better.

It turns out that the performance of a stock index tends to be driven by a fairly small percentage of its components, we’ll say 1 in 10 although it’s typically even less than that. While we may expect a certain distribution here, the actual distribution tends to be even narrower than what would be statistically expected.

The prevailing thought these days is by not holding all of the stocks in an index, you risk missing out on the few that actually do outperform the index by a significant margin. Now over time we may expect that the normal distribution of probability will have this not mattering ultimately, but it can indeed matter in the shorter run if your selection misses out on some of the good ones.

If we look at how this plays out on a year to year basis, during the years where your fund gets “unlucky,” you are going to underperform, and if it does get lucky, you will over perform. Due to the way this tends to play out, it is more likely that you will be unlucky than not in a given year, and this is what they look at here, annual performances versus the benchmark, a fund’s alpha as they call it.

If you don’t want to miss out on any of these bigger movers though, you can just hold them all, and this is what index funds do. In a way, looking at this year over year does stack the deck a bit against actively managed funds, as opposed to looking at much longer term results, but no matter how you slice it, beating indexes with a mutual fund is indeed pretty challenging.

Index Funds Are Also About Minimizing Management Fees

Not only do index funds fail to beat the market, because they are constructed to track these indexes, this approach also is considerably cheaper to manage. For starters, if you employ a passive investment scheme, no skill whatsoever is required to manage it.

Passive management eliminates all decision making from managing the fund, as all the fund does is hold a proportionate amount of each instrument in the index, whether that be particular stocks or bonds or whatever the index is comprised of. If it tracks the S&P 500, it just buys all 500 stocks in the index, and however the index moves, it moves in concert.

There are still management fees involved with passively managed index funds though, as there are still costs involved, including transactional costs, as these instruments must still be bought and sold as required, and there are other costs involved as well of course.

The management fees with index funds do come in quite a bit lower than actively managed funds, which have to hire better and more expensive talent, spend quite a bit of money on research and analysis, and also tend to have higher transactional costs given that their funds do more trading as they seek to move in and out of positions to improve performance.

Should We Go With Actively or Passively Managed Funds?

In order to justify these additional costs, they do have to perform better than index funds, and given that most don’t, if we’re seeking the greater potential of actively managed funds, if we’re looking to beat the market by a meaningful amount in other words, we’re going to have to be pretty selective in the funds we choose.

We may even wonder why so many funds which underperform the market persist in the market, and at least part of the explanation is that most people don’t really do their homework here and are more sold than choose.

So someone will recommend a particular fund to them, and knowing little to nothing about mutual funds, they simply go with the recommendation often times. The person doing the recommending may not be that sophisticated either, and many times they are simply order takers and aren’t really doing much analysis themselves.

Index funds do serve to take all of this out of the equation, whereby the decision comes down to how low the management fees are with one index fund over another, as well as which indexes they track and how well this fits one’s preferences and objectives.

While index funds only represent about 30% of the mutual fund market these days, the world’s biggest mutual funds are all index funds, and index funds have experienced a lot of growth in recent years.

This growth is expected to continue, and index funds are projected to surpass actively managed funds in terms of assets under management by 2024, due in large part to investors becoming more and more familiar with the benefits of index funds.

Actively managed funds can represent even greater opportunities though, provided one is selective enough. Many individual investors don’t really pay much attention to their mutual fund selections though, instead relying on other people to advise, them, but these other people often don’t pay much attention either.

One is always ultimately responsible for one’s own investment results though and should one desire to look to beat the market with one’s mutual fund holdings, to earn higher returns than index funds provide, one must be willing to spend the time and effort in helping make this happen.

Should one not desire to do this, there is always index funds, in addition to all of the other options out there in the investment world. Perhaps nothing beats both your being passive and your fund being passive as well as far as ease of investing goes, if that’s what you’re after.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

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