Passive fund management often brings better returns

By John F. Wasik
Bloomberg News Service

What do you do if your mutual fund company is among the rogues' gallery of funds that have either admitted or been linked to alleged short-term trading practices?

With most funds, you will have no way of knowing if they did anything wrong if they aren't part of legal proceedings since their trading practices are mostly opaque and rarely investigated by regulators. You also have no information on how much their trading is costing you because, by law, they don't have to disclose these costs to investors.

The more pressing question, though, is whether active fund management that involves daily trading is worth the expense and the resulting loss of your retirement dollars.

An untold number of informed investors already have their answer. Even before the recent scandals, investors were discovering that active fund management can be needlessly expensive without adding value to their portfolios.

Dan and Jean Himmel, a retired couple from Fredericksburg, Va., have moved all of their retirement money from conventional actively managed funds into passively managed funds to reduce the cost of investing and their taxes, and to diversify their portfolio.

"We moved our funds to reduce costs," Dan Himmel said, following the advice of his fee-only adviser, Gordon Bernhardt of Bernhardt Advisory Services Inc. in McLean, Virginia.

"Compared to the market, we're doing quite well."

You can do better by choosing a passive investment model, which offers lower costs and higher returns through index and exchange-traded funds. First you have to understand why most active management is a losing proposition.

Any way you look at it, active management is expensive for investors. It's estimated by indexinvestor.com, a passive-investing Web site service, that active fund management costs investors $40 billion a year in the U.S. alone.

Active management means frequent securities trading. Trades incur brokerage commission costs, timing decisions, turnover of securities and capital gains taxes. All of these costs are borne by you, although you can pay a lot less for a passively managed fund and can improve your returns.

A study by Stefan Sharkansky, president of www.personalfund.com, a fund expense analysis Web site, found that the least expensive Standard & Poor's 500 funds, based on the passively managed stock index, "beat 73 percent of actively managed funds pre-tax and 76 percent after tax."

What made the index fund a winner most of the time? Simple subtraction. The index fund didn't have significant trading costs, little or no taxable gains and bare-bones management fees from 0.18 percent to 0.33 percent per year versus as much as 2 percent total annual expenses for the active funds.

"Most people don't have a clue they're being overcharged," said Sherman Doll, an investment adviser and accountant who passively manages $170 million in Walnut Creek, Calif.

Active investing doesn't work because fund managers — like most human beings — consistently fail to outpace the market, which is typically measured by a passive index.

What about the trust we place in managers to time market swings, that is, bail us out when stocks sink and jump back into the market when stocks soar?

Again, active managers didn't make the grade. Fund managers missed all nine major market turning points from 1970-1989, as revealed in a Goldman Sachs study of mutual fund cash holdings.

There's a revolution brewing against active fund management.

What can you do?

Consider investing in low-cost funds offered by the Vanguard Group, Barclay's ishares, TIAA-CREF or Dimensional Fund Advisors. The latter group requires that you purchase shares through an investment adviser or financial planner.

Also avoid index funds sold by brokers, which charge the highest expense ratios among all index funds, according to a recent survey by the Consumer Federation of America. A stock-index fund should charge you no more than 0.25 percent per year; a bond fund no more than 0.50 percent per year.

Becoming a passive investor can improve your returns, although it doesn't mean you should be a passive employee. Lobby your employer to change your defined-contribution retirement plan if it doesn't contain index or exchange-traded funds.