Opinion: Invest efficiently with a passive index fund

Kenny Gott

Mutual funds and exchange-traded funds are baskets of dozens, hundreds or even thousands of stocks or bonds. Many investment advisers and individual investors use them in their portfolios.

It may surprise you to learn that the busier a fund manager is, the worse they tend to perform – so you may do better with simple, low-cost passive index funds that simply track markets.

Old-school, active fund managers buy and sell stocks and bonds, trying to match or beat markets. Their success is judged against a benchmark – a representative sample of their segment of the market, such as large U.S. companies (the S&P 500 index, Dow Jones and others), small companies (the Russell 2000 index, for example), bonds (Barclays index and many others), and so on.

The S&P organization reviews U.S. mutual fund performance in its S&P Indices Versus Active annual report.

Every year, the results show that markets are efficient: Prices adjust quickly whenever there’s new information – and nowadays, new information is available to all investors, including fund managers, more or less simultaneously. Some do beat the market every year, but it’s not the same managers year to year.

Over the long run, fund managers tend to perform about average, minus their expenses and trading costs.

You can find the expense ratio – your annual cost to own a fund – in your fund prospectus.

But fund companies aren’t required to report the managers’ trading costs. Instead, they report a turnover ratio. As an example, 100% turnover means that over the last year, every stock and/or bond was sold and a replacement purchased.

And those trades do cost. 

A 1998 research paper titled “The Official Icebergs of Transaction Costs,” by Plexus Group, established a broad rule of thumb for trading expenses: For every 100% of turnover, assume about 1.16% hidden expense.

So if a mutual fund has 50% turnover, that equates to 0.58% estimated turnover expense. A $500,000 portfolio multiplied by 0.58% equals $2,900 estimated trading costs per year. Right out of your portfolio.

So why doesn’t the trading activity mean better performance, despite the costs? If they buy or sell a stock, they could tell you why they think it’s a good idea. They’re the experts.

But another large 2013 study, “Shedding Light on Invisible Costs: Trading Costs and Mutual Fund Performance” by Roger Edelen, Richard Evans, and Gregory Kadlec, found higher-turnover funds perform an average of 1.92% worse than lower-turnover funds.

The less trading a fund manager does, the better the performance.

Why? Because markets are efficient. The same information is available to everyone all the time. So, a particular fund manager can’t consistently outsmart the thousands of other investors who are all making buy and sell decisions all day long – and those decisions establish the prices of individual stocks and bonds. In other words, a manager can’t consistently predict the movements of the overall markets, or whether any given stock will go up or down, before other traders make the same predictions. So, their expensive trading activity is no more than a steady negative drip against performance. 

Because of this research, many advisers and individual investors have turned to passive index fund portfolios.

An index fund simply mirrors a benchmark index by owning all the same securities that make up the index, or a large representative sample. So, the fund just tries to track the overall market, not beat it. Investment costs and turnover tend to be very low, meaning potentially more money stays in the account working for the investor.

Lower turnover investments also tend to generate less in capital gains taxes, an important consideration in taxable (non-IRA) accounts.

Also, active managers may keep extra cash handy in a fund to buy “hot” stocks as needed. Cash doesn’t generally perform well in an investment – it’s called cash drag. Index funds need comparatively very little cash on hand.

Here’s one more piece to the efficient investing puzzle: the fees you pay your investment adviser. They provide investing expertise, and perhaps additional financial planning, but their fees should be reasonable.

Ask your adviser about your market investment costs and turnover – and look at your investments to see the relationship between lower costs and better performance potential.

Certified financial planner Kenny Gott is president at Piatchek & Associates and author of the book “Bottom Line Financial Planning.” He can be reached at kgott@pfinancial.com.