Predictability of Index Funds

A third advantage of index funds over active funds is their predictability. I am not talking about being able to predict with a glassball what the market is going to do next year. However, I can predict with great accuracy that an S&P 500 index fund will match the performace of the S&P 500 index. In addition, I can predict fairly well what stocks the S&P 500 index fund will hold next year. The reason I say fairly well is because the index changes very little each year, often due to mergers and acquisitions, which I cannot predict. Mutual Fund managers are sometimes known to change their investment style over time. In other words, your Large-Cap Growth mutual fund may slowly become a Mid-Cap/Large-Cap/Growth/Value mutual fund with or without you knowing ahead of time. This is called "Style Drift." Managers of index funds do not practice "Style Drift." That is why they are predictable.

Cost Efficiency of Index Funds

Actively Managed Funds have a professional fund manager making all the calls on trades. The investors pay the manager's salary through a percentage of the invested assets each year. This percentage is called the expense ratio. The expense ratio is made up of management and administrative costs.

The expense ratio differs dramatically between actively managed funds and index funds. For instance, the average expense ratio for actively managed funds is about 1.5%, while the average expense ratio for index funds is approximately 0.25%. That means investors in actively managed funds are paying on average 6 times more in expenses than they are for index funds. That is a high price to pay considering index funds outperform 85% of actively managed funds over many years.

These expenses eat away a large chunk of investors’ money over long periods of time. This especially hurts the investor when the expense ratio doesn't correlate with the performance of the fund.

To help fully comprehend the consequences of investing in high cost mutual funds, here is an example of how much it would cost to hold versus a low cost index fund.

Lets assume both funds earned average annual returns of 11% (11% is the average annual return of the S&P 500 index over the past 30 years) per year for 20 years with an initial investment of $10,000. Assuming the actively managed fund had an expense ratio of 1.5% (active fund average); the holding cost over the 20 year period would have been $21,032. Therefore, after 20 years your investment would be equal to $59,591.

On the other hand, assuming the index fund had an expense ratio of 0.25% (index fund average); the holding cost would have been only $3,937. Therefore, after 20 years your investment would be equal to $76,686.

Now that is a huge difference! In addition, factor in the tax efficiency and the long term superior performance of index funds and you've got a NO BRAINER!!

Tax Efficiency of Index Funds...instant return

Long-term; a properly diversified portfolio of index funds will deliver a superior return than conventional actively managed mutual funds. There are several reasons for this, some more important than others. Today, I’ll talk about the first major factor, which is the tax efficiency of index funds. By their nature, they have a very low turnover rate, which means that index funds distribute very little capital gains (which is taxed) to shareholders. For instance, there are many index funds that are benchmarked to the S&P 500 index, which only had a turnover rate of about 6 percent per year over the last 10 years according to the S&P 500 Directory. Most of this very low turnover was triggered by mergers and acquisitions. Most actively managed mutual funds fail to meet or beat their respective benchmark index funds on a pre-tax basis. On an after tax basis, the index funds beat the actively managed funds by an even wider margin. When we look at the turnover rate of some of Vanguard’s actively managed Large Cap mutual funds, we see turnover rates between 7% and 357% in any given year. However, I must emphasize that the average turnover rate for active funds in general is significantly higher than that of index funds.