Fund Managers Running Scared

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

An index investing strategy is a major threat to the mutual fund industry. When you put your money in a low cost index fund, you are no longer paying the high fees charged by actively managed funds. Each investor with $100,000 in mutual funds with a Management Expense Ratio (MER) of 2% pays $2000 per year in fees. Up that to the $500,000 you’re hoping to have one day and the fees are $10,000 per year. It is no wonder that the managers of these high cost funds are highly motivated to fight against indexing.

Try typing “the case against index funds” into Google. You’ll get plenty of hits. The most amusing hit I saw was called “How to Market Against Index Funds.” At least the title makes the motivation very clear. I read through several of the articles I found while keeping an open mind about the possibility of learning about some real problems with indexing. After all, nothing is completely good or completely bad. Here are some of the main points in the case against indexing along with my thoughts.

Argument #1: Some index funds aren’t very diversified.

This is true to a point. For example the Vanguard Energy ETF is an exchange-traded fund that tracks an index of energy stocks. This fund is for investors who like energy stocks, not for those looking for diversification. The implication of this criticism is that all index funds lack diversification, and that you need an active portfolio manager to be safe from having all your eggs in one basket. This is simply not true.

S&P 500 index funds invest in 500 of the biggest U.S. companies, and the iShares Large Cap fund holds 60 of the biggest Canadian companies. If you are concerned about owning only large companies, then there is the Vanguard Total Market ETF that holds 1200 of the largest U.S. companies plus a representative sample of the remaining stocks. If you are concerned with owning only companies from one country, then there are international index funds. Some of your money could go into low cost bond funds as well, or you could buy a bond directly. There is no reason to pay high management fees to get diversification.

Argument #2: Our gains are more intelligent.

Some of the arguments given by active stock pickers amount to saying that their returns are somehow better than the returns on an index fund because of some vague attribute like intelligence, precision, or global-mindedness. This raises an important question: would you rather make a 10% return intelligently or 12% mindlessly? I’m not advocating investing without thinking, but what matters ultimately to your financial future are results, not the process.

Argument #3: Some people need their hands held.

The argument here is that some people need advice, and if they try to manage their own money they might get nervous and sell at a bad time. There is a lot of truth to this. Many people do panic and sell near a market bottom when they would have been better off just holding on. However, there are two problems with this argument.

How much should people pay for this “steady hand”? If you have $200,000 invested in mutual funds with an average management expense ratio (MER) of 2%, then you are paying $4000 every year to have your hand held. You might consider finding some cheaper way to avoid getting panicky and making poor decisions.

Just because you are invested in actively managed mutual funds does not mean that you automatically have someone there to stop you from making rash decisions. Many people own mutual funds in a self-directed account and are able to trade in an out of funds without the benefit of a friendly expert to calm their nerves. Fund managers may try to hold on to stocks that have dropped in price, but some of the fund’s investors will sell out of the fund forcing the manager to raise cash by selling stocks.

Argument #4: Over such and such a time period active funds beat index funds.

It is true that over some periods of time, actively managed mutual funds give higher returns than index funds. When making this kind of argument, the fund manager has to select the time period carefully, because most of the time, index funds win out. Where actively managed funds tend to win by a very small margin is in periods where the stock market performs very poorly. This is because most funds have to hold some cash (often around 10% of the money in the fund) to deal with the volatility of investors entering and leaving the fund. So over a period of time where stocks don’t do as well as interest on cash, a fund with 90% of its money in stocks and 10% in cash will beat an index fund with nearly 100% in stocks.

However, stocks have been much better long-term performers than cash. The cash component of actively managed funds is actually a factor in their long-term underperformance compared to index funds. For the investor who prefers to buffer bad times in the stock market by holding cash, a solution with lower fees than owning actively managed mutual funds is to own index funds along with some cash.

Argument #5: Some index funds do not have low costs.

This is certainly true. There are fund companies who have tried to jump on the indexing bandwagon and offer index funds, but with high costs to trap the unwary. This is a nice job if you can get it – charging high management fees without having to do much management.

This argument is like saying that medicine is bad because some people sell bad medicine. Investors in index funds just need to pay attention to management expense ratios (MERs) and avoid funds with high expenses.

In summary, I’m not necessarily against active stock picking. What I am wary of is paying a high price in the form of management expenses and other fees for the services of an active fund manager.