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The
funds management world is divided into two camps. There are
active managers, who try to outperform the market, and passive
(or index fund) managers, who try to match the returns of
a particular market index.
At first glance, this looks like a no-brainer
for the investor. Why would anyone pick a passive fund manager
who just plods along trying to match the index when you could
go for an active manager who is trying their hardest to beat
the market?
The reason is cost. Let's say that a particular stock market
index rises 10% for the year. If an active fund manager beats
the market index by 1% but takes out 2.5% from the fund to
cover expenses, investors in the fund will only earn 8.5%
for the year (i.e. 11% minus 2.5%). If a passive manager matches
the index but only takes out 0.5% from the fund for expenses,
its investors will earn 9.5% for the year.
Many studies comparing the two approaches
have been done over the years and the vast majority show that
index funds are the way to go. While active fund managers
may be able to beat the index, they usually don't do it consistently
enough to cover their costs and there is no reliable way of
selecting the best managers.
With this in mind, it is easy to understand why most fund
managers and financial planners have a very dismissive attitude
towards index funds. Acknowledging the superior performance
of index funds is like admitting that they're not smart, or
can't do their job. It is therefore common to hear active
managers describe index funds as "second-best" or
"more for unsophisticated investors."
Most financial planners don't like them either because they
don't pay commissions and they don't give planners much reason
or scope to switch their clients' investments around on a
regular basis.
But don't be fooled by this negativity. The default strategy
for most investors should be to invest in index funds unless
there are compelling reasons to the contrary.
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