You probably heard lately investors found religion in indexing. Money is coming out of actively managed funds and going into index funds and ETFs. After Vanguard’s Personal Advisor Services and Schwab’s Intelligent Portfolio, Fidelity also came out with its Fidelity Go service, which uses index funds. It’s great to see more and more people move into indexing for its simplicity and low cost.
Why would someone even consider investing in actively managed funds then? Besides being misled by an advisor/salesperson who sells actively managed funds for commissions, or when a 401k plan doesn’t offer index funds as investment options, investors choose actively managed funds when they want to beat the market. Whether they are actually able to do so depends on the funds they choose.
I have been with my current employer for more than 10 years. My employer’s 401k plan offers both actively managed funds and index funds. I remember seeing these two funds on the menu when I first joined:
Dodge & Cox Stock Fund
American Funds EuroPacific Growth Fund R6
They are still on the menu today. With no load, an expense ratio in the 0.5% range, and a Gold medalist rating from Morningstar, they can be considered as good actively managed funds. For curiosity I took a look at what if I invested in these good actively managed funds as opposed to index funds in all these years.
I didn’t just pull the 10-year average returns from Morningstar. I wanted to see what if I invested a set percentage of the annual 401k contribution limit into these two funds every year. Because I only had annual returns data, I had to simplify and assume the money was invested at the beginning of each year.
Dodge & Cox Stock Fund
This chart below shows the performance difference in each year between Dodge & Cox Stock Fund and the S&P 500 fund on the menu.
Above zero means Dodge & Cox Stock Fund did better than the S&P 500 fund. Below zero means it did worse. Dodge & Cox Stock Fund did better in about half the years, worse in the other half the years. Although they both invest in U.S. large cap stocks, the difference can be quite large from year to year. In 2008 Dodge & Cox Stock Fund was 10% worse than the S&P 500 fund. In 2013 it was 6% better.
This second chart shows the cumulative effect through the end of each year:
Again above zero means investing in Dodge & Cox Stock Fund did better through the end of that year. Below zero means investing in it did worse. If I invested in Dodge & Cox Stock Fund every year since I joined the company, I would be worse off than if I invested in the S&P 500 fund most of the time. I came ahead briefly in 2013 before I lagged behind again. By now I would be about 5% behind, which happens to be about the same as the difference in expense ratios accumulated during these years.
American Funds EuroPacific Growth Fund
This chart below shows the performance difference in each year between American Funds EuroPacific Growth Fund R6 and Vanguard’s total international stock index fund. The R6 share class is only available in 401k-type plans. It has no load and the lowest expense ratio for this fund.
Above zero means American Funds EuroPacific Growth Fund R6 did better. Below zero means it did worse. The bar for 2016 (as of mid-September) doesn’t show because it’s near zero. American Funds EuroPacific Growth Fund R6 did better than the index fund in most years.
This second chart shows the cumulative effect through the end of each year:
Again above zero means investing in American Funds EuroPacific Growth Fund R6 did better through that year. Below zero means investing in it did worse. If I invested in American Funds EuroPacific Growth Fund R6 every year since I joined the company, I would be better off than if I invested every year in Vanguard’s total international stock index fund. By now my balance would be about 14% ahead even after paying a higher expense ratio every year.
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Here we have two evergreen actively managed funds in my 401k, one behind and one ahead of their index fund alternatives. Coincidentally if I did a mix of 70% Dodge & Cox Stock Fund and 30% American Funds EuroPacific Growth Fund R6, I would be about dead even as the same mix using index funds.
Lessons
What does this exercise show? It shows index funds don’t always win and you can pick a winning fund ahead of time, if only by luck, but it’s hard to score a win overall. These two funds in my 401k plan are probably the 401k committee’s better choices because the more obviously bad choices would’ve been replaced already (see 401(k) Committee Chasing Performance). When you already have index funds as options, be prepared to fail when you take a chance at beating the index funds.
On the other hand, it also shows you are not doomed if you only have actively managed funds in your 401k plan. Investing in two good actively managed funds would’ve got me to about the same balance as investing in index funds. Contributing the maximum and investing with a sound asset allocation are more important, especially when these days most people don’t stay with the same employer for 10 years. When you switch jobs, you can rollover the 401k money into your IRA and invest in index funds there. Even if the funds in your 401k are bad, the negative impact is limited because you won’t have a lot of money in them for many years.
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What If You Invest In Actively Managed Funds? is copyrighted material from The Finance Buff. All rights reserved.