I just read THIS article from Smart Money, they start “With the S&P 500 going nowhere for 10 years, some index investors look for other options…” Then they go to justify the article by saying “it’s heresy for academics, and we can already hear the howls of protests at the very suggestion…Is it time to move beyond the index fund”?

My response to that is: No, I don’t think its time to move beyond the index fund; and yes, I will be part of the protests to the article through this post.

Let’s analyze why. First of all, if you are investing only in a S&P 500 index fund* you are NOT diversified -even when you’d be investing in 500 companies-, you are only investing in a section of the market (U.S. Large Companies). In my opinion, a well diversified portfolio should contain micro, small, medium, and large corporations, and not only in the United States, but internationally as well; it should also incorporate a portion in fixed income bonds, all of it distributed accordingly to the risk tolerance of each individual.

So, saying that index investing is dead based on the performance of only one portion of the total market and during a limited time frame is not only shortsighted, but also -to me- a complete lie. Why?

-First of all, in any given year not less than 60% of funds underperform their indexes according to Standard & Poors (LINK) (there are even categories in which 90% of funds underperform their relative index), so there is a 4 in 10 chance that a mutual fund will perform better than its index; however, the problem is: How to know in advance, and every year, which funds will outperform their index and in which categories? Although it is true that past performance is never guarantee of future returns, I see very unlikely that the tables turn on this one.
The reason? Actively managed mutual fund fees are the most important factor. Management fees are on average 1.3% per year (disclosed in the prospectus, which is mandatory to be given to the investor), and brokerage commissions paid because of the fund turnover could be as high as 1.8% according to THIS study (brokerage commissions are sometimes disclosed in the “Statement of Additional Information”, which is mandatory to be available but is usually not given to the investor). Index funds, on the other hand, can have management fees as low as 0.09% and the turnover is close to 0 (there’s only turnover when the index changes), so the brokerage commissions that index funds pay are very close to 0 as well. So we are talking a possible 3% (rounding 1.3+1.8%) annual expense that the fund would have to overcome just to break even with the index fund. To me, this sounds like a daunting task. Don’t forget that the fund would have to outperform the index by 3% EVERY YEAR just to break even… That’s even a more daunting task. Let me remind you that I’m not considering taxes or sales loads in these numbers, but more on that on a future post.

-Secondly, to declare the index fund dead we need to know that active funds will outperform it consistently in the future. The problem is, nobody can predict the future. Anyone that tells you which are the “hot funds” is chasing past performance return, and that could be devastating for your investments.

-Third, by buying actively managed mutual funds, you are essentially buying the fund manager luck/skill. What if the fund manager retires or moves to another firm? Let’s put the example of Peter Lynch. Mr. Lynch successfully managed the Fidelity Magellan fund and outperformed the S&P 500 most of the years from 1977 to 1990. However, he left the fund. Since his departure, Magellan performance has decreased and has failed to consistently outperform the S&P 500 index. It’s interesting to note that even Mr. Lynch hasn’t been able to pick the next Peter Lynch.

-Fourth, index funds are transparent. With index funds, you know what you own; and if you have a good financial advisor, you will know why you own each piece of your portfolio. Good luck trying to know the holdings of actively managed mutual funds. If any, you will find the top 10 or 20 holdings every quarter, and given the fact that disclosing all of their holdings would be revealing their “trade secrets” to their competition, I don’t think that active mutual funds have a reason to disclose all of their holdings all of the time.

-Finally, index funds don’t switch style/asset classes. What does this mean? Means that if you bought, say an S&P 500 index fund*, it will stay like that the whole time you own it; on the other hand, the managers in active funds have freedom to change their allocations at any time if they believe that other asset categories will do better (in effect, trying to predict the future). So, a U.S. Large cap fund could have a sizable portion of its assets in cash one time for example, changing the asset category in which you were suppose to invest according to your asset allocation.

In short, the “active vs passive” investing has been an ongoing debate for the last 30 years. I believe that index investing is the best way to invest for most -if not all- individual investors, but if you have a different view, please share it through the CONTACT page. And, as always, make sure you speak with your financial professional before making any decisions on how to invest, while you speak with him/her, it would be a good time to ask the 5 questions I posted in THIS article, that way you would know where your advisor stands and if its a good time to find a new one.

This article reflects the views and opinions of Miguel Gomez, a Financial Advisor in El Paso, TX as of 4/27/2009 and are subject to change based on market and other conditions.

If you have any questions, please go to the CONTACT page.

*The S&P 500 Index is a market-value weighted index consisting of 500 widely held U.S. stocks chosen for market size, liquidity, and industry group representation.  Performance is compounded, distributions reinvested.  An investment cannot be made directly in an index.  Past performance does not guarantee future results.