Posts Tagged ‘managed index fund’

The Best No Load Mutual Funds Have VERY LOW Investment Management Expenses

A high ETF or mutual fund can only be justified, if an investment fund earns even higher net returns that compensate for these higher expenses.

Sadly, this is most often NOT the case with costly actively managed equity and bond and with high cost exchange-traded funds (ETFs). In addition, you have no reliable way to tell beforehand which actively managed fund will return more than its added costs. With a passively managed index fund, you are highly likely to get an investment return that is close to the securities market return less your costs.

A higher will tend to cause an actively managed fund to trail the return of . Therefore, your chances of picking a supposedly superior actively managed fund are greatly reduced. Even in the short run, only a minority of actively managed perform well enough to compensate for their higher investment management expenses.

In the longer term, even fewer actively managed stock and bond funds will beat the market, because “superior” short-term performance is mostly due to luck rather than to skill. Luck tends not to last. When the performance evaluation time period gets longer, then there are fewer and fewer actively managed with net performance that is better than a passively managed index fund targeting a market return. Actively managed are simply not reliable vehicles to plan for your family’s long term financial needs!

The average actively managed mutual fund manager demonstrates some skill, but the added costs swamp this additional investment return.

Certain scientific studies have demonstrated that some professionally managed equity seem to exhibit a modest level of apparent skill in their ability either to choose stocks and bonds and/or to manage their stock and bond portfolios. These mutual fund managers may be slightly better stock pickers, and/or they may have better portfolio management practices.

In managing their portfolios, these mutual fund managers may not make the behavioral mistakes that many individual investors do. Examples of behavioral investment mistakes are holding on to losers too long and selling winners too quickly.

Scientific finance studies have demonstrated a very slight persistence in stock price trends for some, but not all equities. This persistence could benefit portfolio managers who hold their winners longer and sell their losers more quickly. Evidence of superior skill for bond fund manager seems entirely lacking, so buying no load bond funds is very clearly a better strategy.

Most professional investment fund managers have expertise, but efficient market competition tends to make them all mediocre in the long term.

Just because scientific finance studies do not support buying actively managed stock and bond funds on a net returns basis, this does not mean that professional money managers are not skillful. To the contrary, the level of professional expertise in portfolio management at most fund companies is very high. However, unlike American schools and colleges, the real-time securities markets have built-in grade and achievement deflators.

On average, the markets deliver C level returns before costs. If your costs are lower, you are more likely to get an A or B. If your costs are higher, you are more likely to get a D or F. The major factor that adds to all the confusion is that market participants must put a current, risk-adjusted value on the future economic prospects of their potential investment holdings.

These highly uncertain predictions make securities market prices highly volatile. After the fact, market participants will eventually be graded on the future value impacts of currently unknowable future events. Some investment fund managers will be lucky, while others will not be in the short run. In the long run, their investment fund manager performance usually averages out.

Minor, short-term skill demonstrated by some active professional investment fund managers, perpetuates the completely spurious active management versus passive management “debate.”

From the perspective of the individual investor, this tired active management versus passive management “debate” or argument is simply and completely irrelevant. Scientific finance studies have the advantage of being done after the fact, and they use large sets of historical investment fund performance data to see what actually did happen. Some studies provide continuing fuel for self-interested industry promoters to keep saying that actively managed provide value.

However, without a crystal ball, individual investors instead face the daunting task of trying to pick some of the few future winners out of a very large crowd of investment fund managers who will not provide a positive net return. The active management debate implies that after all the additional costs, mutual fund trading costs, higher capital gains taxes, and extra time are taken into account, investors are supposed to have some crystal ball to sort future winners from losers.

Nobody has such a crystal ball. The closest approximation to a crystal ball that is available is the simple rule to only buy very low cost and ETFs. All very low cost and ETFs are passive investment funds.

The investment fund management industry keeps pointing to past performance and Morningstar ratings as predictors, when superior past performance and 4-star and 5-star ratings are completely useless predictors. Instead lower costs and lower turnover are far superior predictors of future mutual fund performance.

Even the scientific studies that demonstrate some professional skill, do not show that this incremental skill justifies paying the much higher fees of active funds. On average, actively managed funds simply do not have sufficiently higher returns to cover even their higher direct management expense ratios.

The research shows that added costs typically outweight added performance by about 2 to 1 or 3 to 1. And, this does not even count the higher trading costs and the deadweight loss that individual investors are subjected to when they pay investment sales loads and 12b1 fees!

How is that for an “active” mutual fund or ETF investment return?

Spend 2 or 3 or 4 dollars more to get a dollar back! Waste your valuable time trying to figure out which funds will demonstrate better performance. Take the risk that you could pay far more and still end up picking one of the worst rather than one of the “best” actively managed funds, after the results are in. Do this over and over across your lifetime. Sounds fun, huh?

Did you know that one investment research study on growth demonstrated that there was a 12 to 1 ratio between the cumulative returns of the best performing growth mutual fund to the worst performing growth mutual fund over the 19 year period from 1976 to 1994?? (See: Edward S. O’Neal, “How Many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?” Financial Analysts Journal, March/April 1997: 37-46)

Sound ridiculous to you? For the slimmer chance of winning the investment manager selection lottery, do you want to roll the dice and end up with a terrible fund or a series of terrible funds instead? Perhaps this is not the best way to plan your family’s financial future.

Why bother listening to this completely self-serving securities industry “debate,” when you can simply buy very low cost, broad market index and ETF, and then get on with your life? Do you really want the pleasure of spending a lot of time in your life listening to one financial advisor after another tell you that a succession of expensive investment funds are “better”? Then, do you want the excitement of watching these “better” funds perform over time, when they are far more likely not to be better as time passes and as your portfolio is harmed?

Furthermore, higher active transactions costs are most often hidden and left out of the comparison, even though higher active fund trading costs can will drag down net returns for higher turnover funds. Also, these studies usually do not account for increased taxes paid by individual investors caused by active trading. Finally, they do not measure the opportunity cost related to an individual investor’s extra time spent on futile, ongoing efforts to pick “superior” funds that most often will not be.

An individual investor is far better served by choosing from among the numerous passive, noload and exchange-traded funds that have decided to compete on low costs.

Obviously, a decision rule that focuses on lower fees will strongly favor passively managed over actively managed funds. You will have more choices than you need, if your restrict your investment fund choices to those passively managed and ETFs that are trying to attract individual investors’ money by charging very low fees. Low cost passive investing is one of the fundamental essentials of investments for those who want to adopt a smart investing strategy. When choosing between load or no load , there is no comparison. Cut out the expenses, including advisor sales loads and fund management expenses, and you end up with passively managed that are much more likely to deliver better risk-adjusted returns. This is simply one of the basics of investing.

When screening and ETFs, you should first set a relatively stringent upper limit on the annual expense ratio that you are willing to pay. With passively managed domestic , .5% annually is an overly generous upper limit. Many domestic are available with management fees under .25%. Because of their variety, it is not as easy to generalize about screening international and global . However, much lower management expense ratios should still be the key screening rule for these non-US funds.

With actively managed , you first really should ask yourself whether you have a valid reason for still preferring them over passively managed . If you still have a good reason to select an actively managed fund, which most individual investors will not have, then you should still seek lower management expense ratios among active funds. You might start screening with an upper expense ratio limit of .75% and then move lower. Obviously, you should also amortize any sales loads that you cannot avoid. Again, however, there is never a good reason to pay a front end sales load or back end sales load. There are many better noload available for you to buy directly from no load mutual fund companies.

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