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FINANCIAL PLANNING FIB #4
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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