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Index Funds vs. Actively Managed Funds: Cost vs. Cost-Justification

| March 02, 2020
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(This was posted on 4/29/2015.  I've taken it from my old blog site.)

Lots of talk these days about making sure you have low-cost mutual funds. All things being equal, yes, the lower the internal costs of a fund, the better. Assuming, that is, you are talking about funds that invest in the same way and get similar returns...

But all funds are not equal and do not all invest the same way. Some fund managers are better at picking investments, and they get better returns. You can do better if you choose those benchmark-beating funds.

Think of a football team... the same playbook and strategy would be more successful most of the time if all-pro players were on the team. That is what my Strategic portfolios aim to accomplish--the mutual fund versions of a team with "all-pro players" on the field for us.

These "all-pro" funds cost more than the low-cost index funds, but that should not matter if their net performance is better. If one fund delivers net-of-fees performance of 7.5% per year and another 7.0%, why be concerned about how much each fund charges?

Uncertainty is the only reason--we don't know if the outperformance will continue. But if we find funds with consistent track-records over several market cycles, we can have confidence that they really are better at investing.

But these funds are hard to find. 80% of actively-managed funds underperform their benchmarks. How does one know which are in the 20% that outperform? Can't figure that out for yourself? I will do it for you for about 1.25% per year. I know what to look for, and I have the tools--my firm's most expensive overhead cost is the research database with which I hunt for the actively-managed mutual funds that are worthy using.

And even if the cost-justification makes it merely a wash compared to using index funds, you still have me on retainer to help with personal financial strategy and advice: how much to save, which accounts to use, buy or rent a home, lease or finance a car, what kind of insurance to buy...

There is Nobel Prize-winning research that guides most financial advisors on how to diversify portfolios. If we're following that asset allocation guidance, then portfolios using benchmark-beating funds should do better most of the time and over the long-haul than those using index funds, even if the latter have lower costs. The Strategic portfolio models I offer will have beaten strategically similar models comprised of index funds, and over just about every time period.

 

To summarize, index funds are all pretty much the same, so go for the ones with the lowest cost... but a well-constructed portfolio of the best actively-managed funds should beat that, and even if you don't know how to do it yourself, an advisor like me can do it in a way that cost-justifies the additional advisory fee. Value. Cost-justification. Good stuff!

I appreciate your time. Thank you for reading this post.

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