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The Verdict is in—Again: Mutual Funds vs. The Entire Market

Actively managed mutual funds typically deliver a lower return than simply buying the entire market.

Articles by Boris Khentov

By Boris Khentov
VP of Operations, Betterment  |  Published: April 24, 2009

Standard and Poors, the entity that publishes financial research and analysis, just released its latest year-end report on mutual funds. The conclusion is not surprising for those of us who are converts to index fund investing. Actively managed mutual funds typically deliver a lower return than simply buying the entire market, not even accounting for the fact that you pay more in fees for that “active management”:

Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P MidCap 400 outperformed 79.1% of mid cap funds and S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.

But what about in down times? Surely, when the market is falling, having a steady, experienced hand on the tiller should be an asset, right? Turns out, no:

The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes.

Jack Bogle, the founder of Vanguard, started preaching for index funds back in the 70’s. Since then, more and more have come around to the idea that picking stocks and trying to “beat” the market is a fool’s errand. More recently, one of my favorite journalists, Michael Lewis, profiled one such convert, Blaine Lourd. I highly recommend this piece – Lewis has a deep understanding of markets and knows how to tell a story to a wide audience.

The illusion of success for active stock picking can be hard to shake. Some people genuinely do beat the market, many times over. But let’s say that the odds of beating the market in any given year are 10%. If 10,000 investors try to beat the market for four years in a row, one of them, statistically, will actually succeed. Is this man a financial wizard? No, he basically won the scratch-off lottery (though probably netting a whole lot more). People will flock to this guru, falling over each other to give him their money. They will be warned, of course, with that famous phrase that says it all: “past performance is not an indicator of future results.”

Can you win, and win big, if you pick stocks? Yes. But, what we’re building here at Betterment is not for people who view their savings primarily as a gambling chip, or who get off on the daily movements of the market. If you enjoy that (and some of us do!) then that’s what casinos are for. What we want to provide is a place for people to invest in the simplest way possible. That reduces the whole enterprise to one question: how much risk are you comfortable with? Leave picking and choosing individual stocks to those fund managers, who, as a whole, consistently underperform the index strategy. We want to distill the investing process to the basic components, and present it with no embellishments. We hope you will join us.

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