Monday, June 24, 2013

SMART INVESTOR: It's Getting Harder And Harder To Deny The Power Of The Almighty Index Fund

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Monday, June 24, 2013

SMART INVESTOR: It's Getting Harder And Harder To Deny The Power Of The Almighty Index Fund

A new white paper by Portfolio Solutions and Betterment, "The Case For Index Fund Portfolios,"pretty much solidifies all we've ever known or guessed about low-cost, passively managed index funds –– they can rarely be beaten.

Looking at advanced portfolios holding 10 asset classes between 1997 and 2012, researchers found index fund portfolios outperformed comparable actively managed portfolios a staggering 90% of the time. And the longer investors held those investments, the better shot they had at outperforming active funds over time.

Still not convinced? Even lowering the cost of actively managed fund portfolios couldn't offer a boost significant enough to outperform index funds, the researchers found.

“The outcome of this study statistically favors an all-index fund strategy, all the time," the report says. "The probability of outperformance using the simplest index fund portfolio started in the 80th percentile and increased over time and with additional asset classes. These results have significant and practical implications for investors who seek a strategy that can give them the highest chance of reaching their investment goals.”

What makes this study so unique isn't that it just confirms what we've already known about index funds for some time –– that they consistently beat actively managed funds –– but that they've shown that owning more than one actively managed mutual fund in the same asset class could be "detrimental to the active portfolio."

This study further deepens the evidence that an all-index fund portfolio is difficult to beat, leaving only the task of finding a simple, low cost way to do that," writes co-author Alex Benke, CFP and Product Manager at Betterment.

The paper outlines three specific advantages index funds have over actively managed funds, which they call Passive Portfolio Multipliers (PPM):

1. Portfolio advantage: Index funds have a higher probability of outperforming actively managed funds when combined together in a portfolio.
2. Time advantage: The probability of index fund portfolio outperformance increased when the time period was extended from 5 years to 15 years.
3. Active manager diversification disadvantage: The probability of index fund portfolio outperformance increased when two or more actively managed funds were held in each asset class.

active vs passive investing