(Forbes) -- In a recent post, I shared thoughts about why index funds and ETFs aren’t good investment options for most investors. The post referenced research Fidelity published titled, “Dramatic Misperception of Passive Outperformance.”
After having email and telephone conversations with a number of readers, I am now convinced that index investing is a bad investment strategy for most investors. Here’s why.
Let’s start with a good example
I believe there are compelling actively managed options in nearly all asset classes. Following is an example in the mid-cap asset class.
The T. Rowe Price New Horizons Fund (PRNHX), which went through a management change on March 31, 2019, comfortably beats its benchmark on a 10-year basis (22.09% versus 17.60% through March 31, 2019). That is very significant outperformance. It’s one of the best mid-cap growth funds for that period -- out of more than 500 funds. It is a five-star Morningstar-rated fund.
The best passive mid-cap comparator fund is probably the Vanguard Mid-Cap Index Fund (VIMAX), which has a 10-year performance of 16.67% versus its benchmark of 16.87% through March 31, 2019.
I can’t see why anyone would throw up their hands and say, “There is just nothing better in the mid-cap space than an index fund.” Nearly 5% outperformance over 10 years is an incredibly large performance differential.
Not every active manager in the mid-cap space needs to beat its benchmark to convince me I have an adequate choice with actively managed mid-cap funds.
However, just because I can find great actively managed choices in most asset classes does not mean that index investing strategies are not good. Here is a better reason.
Factor in financial advisor fees
Many Americans don’t know a lot about investments. And that’s OK. Most of us are busy with work, our families or just trying to get a little sleep. A lot of these individuals who are serious about investing end up hiring someone to provide investment advice.
That’s a good decision when you don’t have the time or interest to tackle investing by yourself.
However, every financial advisor charges a fee. These fees are generally around 1% for balances less than $1 million.
Extending the example above, if an advisor charging a 1% fee placed an investor in the Vanguard Mid-Cap Index Fund for the 10-year period ending March 31, 2019, that investor would have earned 15.67% compared with the benchmark return of 16.87%.
If the advisor had placed the investor in the T. Rowe Price New Horizons Fund for the same time period at a 1% fee, the net return to the investor would have been 21.09%. Not only does that return comfortably beat the fund’s benchmark return of 17.60%, but it is 5%+ more than the investor would have earned with an index fund investing strategy.
It doesn’t appear to make sense to pay for an indexed strategy
For most Americans who hire a financial advisor, an index approach probably isn’t the best option. Index funds and ETFs work great in some asset classes, for those investors who are comfortable working without an advisor and for those investors comfortable living with average performance each and every year.
If you are going to pay for investment advice, it doesn’t seem to make sense to use a passive investment strategy. Doing so guarantees returns, net of advisor fees, that are below average.
Why would anyone do that?
ESG exposure is another reason
Financial Advisor reports that 62% of all American workers are concerned about the environmental, social and governance (ESG) records of the companies they invest in.
As investors become more interested in including ESG factors in their decision-making process, they probably will find that an actively managed approach proves more successful. To see why, take a look at a recent article in ThinkAdvisor that outlines the difficulties the managers of ETFs have in controlling ESG exposure.
The winning formula uses a mix
Without question, the best way to build a great investment strategy is to use index options for those few asset classes that are widely covered and researched and actively managed choices for all other asset classes where inefficiencies still exist.
It is clear that passive outperforms in the large-cap asset classes, but in nearly every other investment category, active management appears to be the better choice.
This is not investment advice
None of the investment options discussed in this post should be considered as investment recommendations.