"I can't believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best. -- Edward C. Johnson III, Fidelity Investments
One of the most hotly contested topics in mutual fund investing is the argument for low-cost passively managed funds over high-cost actively managed funds. Passively managed funds aim to replicate the returns of a given index minus expenses each year. Actively managed funds attempt to beat the market through market timing and excessive trading. Over time, all mutual funds tend to revert to their indexed mean, or market average. The one variable which puts passively managed funds ahead is their attention to low costs.
A passively managed index fund seeking to replicate the performance of the Standard and Poor's Index will only incur trading costs when the S&P committee decides a stock is to be removed due to a merger or bankruptcy. An actively managed fund incurs trading costs in a futile attempt at market timing.
Investors who shun index funds believe that they can find a money manager, in advance, who will beat the market the following year. Yes, a few will beat the market, but not over long periods of time. Active managers face hurdles which make their job near impossible to reliably come out ahead.
The first hurdle faced by actively run funds is excessive turnover. For many funds, turnover exceeds 100%. This high churning and trading reduces annual returns by about 1%. Management fees can average 1.5% in addition to 12-b1 fees to cover advertising. Starting the year in the whole by 2% or more virtually guarantees that actively run funds will lag passively-managed index funds.
Another hurdle which managers face is known as asset bloat. If an active money manager has a winning year, it is assured that his company will promote his fund to the hilt during the ensuing months. He now has to invest this new money in the attempt at beating the markets again for his new investors. The downfall is that with this much money to invest at any given time, prices are pushed up when purchasing and fall when selling. Any advantage he may have had when the fund was smaller is now gone.
While researching which funds to invest in, many inexperienced investors choose the highest rated funds based on past performance. This is a recipe for disaster as many have learned the hard way. The best long-term strategy is to simply create a portfolio of low-cost index funds that earn market average returns each and every year. Such a strategy will put you years ahead of others on the path to financial independence.
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