Index Funds vs. Actively Managed Mutual Funds – How to Choose

One of the most common pieces of investment advice goes something like this:  “If you want to be a successful investor, put your money in low cost, passively managed index mutual funds.”  It’s offered freely – in magazines, via social media, TV interviews, books, and blogs  – by writers, professors, even strangers at cocktail parties.  This advice is bestowed upon us with the confidence deserved by only the truest of universal truths.  The idea here is that by investing your money in low-cost index mutual funds, you can’t go wrong, and you will reach your goals.  All things being equal, low costs = successful investing.  But it’s just not that simple.

Mutual funds with low fees are almost always a good thing, but they don’t guarantee a successful investment program, nor do they guarantee that you’ll reach your goals.  You can’t simply put some money in an index fund and hope for the best 20 years from now.  You still have to contribute enough to sufficiently fund your goal.  For example, investing $1,000 per year in low cost index funds probably won’t sufficiently fund your retirement.  Plus, you’ll still need to establish your asset allocation (the relative exposure to stocks, bonds, real estate, and other assets), and either rebalance or change the allocation from time to time.  You still have to assemble a balanced combination of mutual funds to create your portfolio.  So I hope for your sake that for retirement, you are not simply putting investing in a handful of index funds, and believing that things will be just fine.  At the end of the day, this decision (low-cost index vs. higher cost active) should not necessarily form the core foundation of your financial plan.

Telling the world that a low-cost approach guarantees success is no different than saying, “If you want to be a good cook, use only the freshest, locally-sourced organic ingredients, the highest quality cook ware, and most important, a gas stove top rather than an electric.”  But let’s face it:  you can use the finest ingredients and equipment, but at some point, you have to cook.  And it’s possible that your food won’t taste very good.  That’s how it is with investment portfolios. You can use one, five, even 10 low-cost index mutual funds, but you still have to assemble them into a sound portfolio.  And that portfolio may change over time (the allocation, the funds, etc.).

Let’s look at an example in which you need to select a fund that invests in large, domestic companies (aka “Large Blend”) for a portion of your 401(k) portfolio.  Large Blend funds invest in the same types of companies that comprise the S&P 500 Index; household names like Microsoft or Johnson & Johnson.  There are 500 U.S. companies in the index.  Here are your choices (Vanguard 500 Fund, Fidelity Large Cap Stock, and GMO Quality V):

Source: Morningstar.com

Of you three choices, one of them (the Vanguard 500 Index Fund) strives to track the Vanguard 500 Index as closely as possible.  The other two seek to invest in the same types of companies, but attempt to perform better than the Vanguard index fund (by making tactical decisions about which companies to buy and sell, and when).

Some observations:

  • I’ve listed the annual expense ratios for your reference, but please note that the returns listed are after all fees have been deducted.
  • The other two funds invest in far fewer than 500 companies (as does the Vanguard 500 Index).  The GMO fund is quite focused (86 companies), and the Fidelity fund also somewhat focused (208 companies).  Even more eye-opening, take a look at “% of Assets in Top 10 Holdings”:  10 of the 86 companies in which the GMO fund invests make up over 41% of the fund’s assets.
  • “Alpha” measures how many percentage points the fund out-performs (or under-performs) its benchmark index (the index to which it is compared), which in this example is the S&P 500 Index.  This out-performance is typically attributed to the manager.  You can see that the Vanguard fund (which is not trying to out-perform its index, but rather mimic it) has a slightly negative Alpha, which is almost exactly equal to its Expense Ratio.  This makes sense.
  • “Beta” measures the fund’s volatility relative to its benchmark index.  You can see that the Vanguard 500 Fund is exactly as volatile as the S&P 500;  the GMO Fund is 74% as volatile;  the Fidelity Fund is 114% as volatile.  (This means that if the S&P 500 goes up 10%, the GMO Fund should go up roughly 7.4%)

How to Assess the Choices

One easy way to see whether you’re getting your money’s worth with a pricier, actively managed fund is to simply compare the annual (calendar year) performance numbers with other similar funds.  This approach allows you to evaluate how the actively managed funds perform (vs. the Vanguard 500 fund) in both up and down market cycles.  Does your actively managed fund consistently outperform the Vanguard 500 fund, or did it get lucky once or twice.  Plus, if it is outperforming the Vanguard 500 fund, is it doing so only by taking on extra risk (with your money).

We can see that over a 5 year period (2009 – 2013), the GMO Fund underperforms the Vanguard 500 Fund, and the Fidelity Fund outperforms the Vanguard 500 Fund – in every year except one (2011).  The Fidelity Fund provides the highest 5-year average annual return of the three funds.  So, based on this approach, one might be inclined to go with the Fidelity Fund (bearing in mind that it’s 14% more volatile than the Vanguard 500 Fund).

But are there other ways to assess a fund’s performance that factor how much risk the fund manager is taking?  Yes there are, and you don’t even have to calculate it, because Morningstar.com has already done so.

The Sharpe Ratio

The first option is the Sharpe Ratio, which measures what’s called “risk-adjusted return”.  It addresses how much risk (volatility) the fund manager took in order to earn the fund’s returns.  This formula is a useful way to compare multiple investments.  The higher the Sharpe Ratio, the stronger the investment is on a risk-adjusted basis (even if it’s not the highest performer).  For your reference, the formula is as follows:

(EXPECTED RETURN – RISK FREE RATE OF RETURN) / STANDARD DEVIATION

The Sharpe Ratio creates a measurement of return/risk (with “risk” in this case meaning the portfolio’s “standard deviation”).  Standard deviation is a measure of historical volatility, or how erratically the returns in the portfolio fluctuate relative to the market.

Here’s a simple example:  Two investments with the different returns, but the lower performer takes on less risk:

Investment Return Risk-Free Return Standard Deviation

Sharpe Ratio

A

10%

1%

18

9/18 = 0.500

B

7%

1%

9

6/9 = 0.667

According to the Sharpe Ratio, investment B is a better deal because even though it’s actual return is lower than A’s, it delivers more return per unit of risk.  The investment manager isn’t swinging for the fence, so presumably, you’re getting a better bang for your risk budget.

The Treynor Ratio

The Treynor Ratio is also a return/risk equation (below), but in this case the “risk” used is the portfolio’s “Beta”, described above.

(EXPECTED RETURN – RISK FREE RATE OF RETURN) / PORTFOLIO BETA

Morningstar provides both the Sharpe Ratio and the Treynor Ratio for the three funds on a 3, 5, and 10 year basis, so if you’re looking to choose an investment based on “risk-adjusted” returns, you can find that information on Morningstar.com, which provided the data in the two charts below.

Sharpe Ratio

 

3 Year

5 Year

10 Year

GMO Quality

1.42

1.44

0.48

Fidelity Large Cap

1.10

1.33

0.47

Vanguard 500

1.09

1.35

0.46

Treynor Ratio

 

3 Year

5 Year

10 Year

GMO Quality

19.24

21.69

7.00

Fidelity Large Cap

13.90

18.84

5.99

Vanguard 500

13.59

18.89

5.94

When we look at these risk-adjusted return figures, it becomes clear that the GMO fund provides the greatest returns per unit of risk, even though its actual returns tend to lag the other two funds.

Is There a Clear Winner?

After all this analysis, does any one fund of the three stand out as the clear winner?  It all depends on what you’re using as your basis of choice.

Expense Ratio:  If low expenses are most important, then the Vanguard 500 Fund is for you. With an annual Expense Ratio of 0.17%, it’s the lowest cost fund.  In fact, the Vanguard Fund is 0.67% less expensive per year than the Fidelity Large Cap Fund, although the Fidelity Fund out-performed the Vanguard 500 Fund in 4 of the past 5 years by far more than 0.67% per year (roughly 35% in total over 5 years).  But you saved 0.67% per year!

Pure Performance:  In the case of these three funds, the Fidelity Fund delivered the highest returns (but with the greatest amount of risk, or volatility).

Risk-Adjusted Returns:  As we saw above with the Sharpe and Treynor Ratio measurements, the GMO Fund delivers the greatest return for the amount of risk it takes.

A Devil’s Choice?

When it comes to your financial health, and achieving your goals, the “choose the lowest cost index fund and nothing else” approach strikes me as a devil’s choice.  It’s like the old “rock vs. disco” argument that was so pervasive in the ‘70s.  And if you’ve fallen for that one, then you’ve probably never enjoyed the Electric Light Orchestra, Paul McCartney from 1977 – 1982, or any band from Brooklyn.  Can’t you use both, and why must you choose between the two?

To successfully achieve your goals, you need access to every tool and every advantage you can get.  In most cases, it won’t come down to one thing.  Low costs don’t necessarily guarantee success, and limiting yourself to one investment strategy does not a financial plan make.  Use both if you need to, but don’t forgo the opportunity to participate in your 401(k) plan simply to avoid mutual funds that have a 1.5% expense ratio.  For every dollar you contribute to your 401(k) plan, you are 1) saving another dollar toward your retirement – a good thing, and 2) lowering this year’s tax bill.  Depending on your Federal, State, and City tax brackets, you could be saving 35 cents or more in taxes on every dollar you contribute (before employer matching contributions).  This indexing debate will outlast us all.  Let it be.

Daniel D’Ordine, CFP® is the owner of DDO Advisory Services, LLC, a full service financial planning and investment advisory firm in New York City and Rhinebeck, NY.
Follow me @DDOadvisory.

Comments are closed.