Index funds may sound boring, but in his latest New York Times column, Mark Hulbert offers some data that indicates index funds may, in the end, actually yield higher net returns than mutual funds and even hedge funds.
Hulbert details a study performed by Mark Kritzman, president and CEO of Windham Capital Management and a professor at M.I.T. In the study (presented in the Feb. 1 issue of Economics & Portfolio Strategy), Kritzman developed an complex method to measure the performances of thee hypothetical investments over a 20-year period — a stock index fund that averaged a gross return of 10 percent per year; an actively managed mutual fund that averaged 13.5 percent; and a hedge fund that returned 19 percent. Because the amount of taxes taken out of investment gains depends on the order and combination of positive and negative years, Kritzman factored in what he determined to be the industry average volatility for each investment, as well as the average turnover rate and fees, Hulbert notes. He used the tax rates of a New York state resident in the highest tax brackets.
The final results, after all those taxes and fees were factored in: The index fund averaged an 8.5 percent annual gain; the actively managed fund averaged 8 percent; and the hedge fund averaged 7.7 percent.
“Expenses were the culprit,” Hulbert explains. “For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.”
There’s more: “Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis,” Hulbert writes. “For the hedge fund, that margin would have to be 10 points a year.”
In its database, Morningstar has 452 equity mutual funds that have been around for 20 years, Hulbert says, and just 13 of those (less than 3 percent) have beaten the S&P 500 by an average of at least 4 percentage points a year over those two decades. And Hulbert’s article also points out that, while we know now that those funds outperformed significantly over 20 years, it would be very, very difficult to know that they would have done so in advance so that you could have reaped their gains.
According to Kritzman, “It is very hard, if not impossible to justify active management for most individual, taxable investors, if their goal is to grow wealth,” adding that investors who insist on actively managed funds are almost certainly “deluding themselves,” Hulbert notes.
Index funds may well be the best choice for tax-sheltered accounts like 401(k)s and I.R.A.s, Hulbert adds, writing: “In that case, Mr. Kritzman conceded, the odds are relatively more favorable for active management, because, in his simulations, taxes accounted for about two-thirds of the expenses of the actively managed mutual fund and nearly half of the hedge fund’s. But he emphasized the word ‘relatively.'”
“Even in a tax-sheltered account,” Kritzman said, “the odds of beating the index fund are still quite poor.”
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