Index Funds vs. Actively-Managed Funds: Which Is Better?

I often write about this in e-mails.  Now I'm blogging about it again, as a couple of clients have raised the issue of "index funds" recently...

 

Mutual funds come in basically two varieties:  actively-managed (the normal kind), and passively-managed (the so-called "index" funds).  I prefer actively-managed funds--but only great ones--for most of the portfolios I craft for my clients.

Actively-managed funds are run by a manager (usually with a team, or sometimes a team of several managers and their staff of traders and analysts).  The fund, as directed by the manager's strategic portfolio plan, will invest as well as it can in the area(s) of focus.  For example, the Yacktman Focused Fund I use a lot aims to invest in stocks of large, well-run, financially-sound American companies that are trading at prices below what the fund thinks is "fair value".  If it does well, like Yacktman Focused fund has for a long time, the fund will outperform the benchmark index to which it compares itself (the S&P500 index, in this case).

But actively-managed funds, as a category or breed, usually do not outperform the benchmark.  Estimates are that ~80% of actively-managed funds fail to beat their benchmarks--successful investing is not easy, and the costs of running a mutual fund eat into the hard-fought outperformance a successful manager achieves.  So, many investors and advisors feel the better choice is to simply "invest in the benchmark".  Well, we can't actually buy part of an index, but "index funds" replicate their target benchmark index very closely, and well-run index funds can do so with efficiencies and economies-of-scale that make the funds very low-cost.

Fund performance data is reported net-of-fees (not my advisory fee, mind you, but net of the funds' internal management fees).  So when you see Yacktman Focused Fund compared to, say, the Vanguard 500 Index fund, it should be comparing apples to apples (net of fees).  If Yacktman has beaten Vanguard by 3.15% per year over the past decade, that's accounting for the 1.25% annual internal fee Yacktman takes and the 0.17% fee taken by Vanguard 500 Index fund.  So the Yacktman Focused Fund has a 1.08% fee differential to make up for just to be even with Vanguard 500 Index fund.  Since Yacktman beat Vanguard by 3.15% per year net of fees, it means the managers actually outperformed by 4.23 percentage points per year over that 10-year span.

That kind of cost-justification is the bottom-line that should be sought by investors and advisors.  Of course, if 80% of actively-managed funds don't cost-justify like that (or anywhere near like that), then it's a good bet to go with an index fund...  unless the investor, or their advisor, knows how to find the funds that are likely to cost-justify.

I use actively-managed funds.  I'm one who enjoys the research/vetting part of this job, and I have great tools/resources to help me.  I believe I find the best actively-managed funds for each category and put together portfolios that beat their benchmarks over most or all significant time periods.  Hence my "80 Strategic II" portfolio for moderately-aggressive long-term investors, for example.  It has the following track record compared to its "blended benchmark" (proportionate amounts of the S&P500 and other indexes for bonds and for foreign stocks):

Span      80 Strategic II   ModAggr Benchmark

3mo         0.46%             -0.32%

1yr         7.00%             7.01%

3yr         15.02%            13.41%

5yr         12.64%            9.61%

10yr        8.94%             6.45%

2008 crash  -30.02%           -32.03%

2009 rebound +41.45%          +23.56%

No guarantees this will continue, but the point is that finding and using the few actively-managed funds that do outperform over the long-haul has been a better choice then using index funds.

But for those who don't know how to find the right funds, or for retirement plan administrators that want to play it safer (not risk offering a bunch of funds that turn out to be underperformers), index funds are appropriate tools.

Fed To End Quantitivate Easing

Probably the biggest thing the U.S. government has been doing to stimulate our economy in the wake of the 2008 financial crisis and recession has been something called "quantitative easing".  It is pretty much the practice of the Fed buying bonds from the Treasury to stimulate the economy.

Those bonds are sold to give our government more operating cash, to either pay bills coming due or spend the money on necessary services and/or projects that our leaders believe will be stimulative to the economy.  Sometimes, like I understand is the case now, the Federal Reserve actually prints new paper money with which to make the purchases.  The risk is inflation in the future, but such risk is taken with the intention that the short-term stimulus effects are worth the risk.

Now the economy is growing.  Slowly and not necessarily surely, but measurably and postively.  The Fed is thus in the middle of tapering the Quantitative Easing, creating a glidepath to ending QE (it had been buying $85 billion worth of bonds every month).

But last week one normally hawkish Fed big shot was surprisingly outspoken--and dovish.  He said the Fed would not necessarily end QE as planned, impying that the Fed would help the securities markets if need be (we were in a market decline last week, and he is thought to have been speaking to that matter with intent of reassuring investors)...  Word is, though, that most of his peers (including those with a vote on the matter, which I believe this one fellow does not have) intend to end QE for sure.

In short, the nFed is said to be on track to end QE, even if one of its members may have spoken his opion of what should be done instead of saying what the Fed will do.

Bill O'Grady (not Bill Gross--I cite each pretty often and want to be clear:  O'Grady is the global investment strategist/thinker, Gross is the manager of bond portfolios and mutual funds) writes today about this.  See the second and third paragraphs in the item linked here:  http://confluenceinvestment.com/assets/docs/2014/daily_Oct_20_2014.pdf

Okay, I wanted you to know the basics in case it is not clear.  I hope it helps.  Please contact me with any questions.  Thank you.

--Gary

Gary Partoyan

Potomac Wealth Strategies, LLC

(703) 746-8195 direct

Visit us online for helpful ideas and information!

Strategic, Flex, and Index Portfolio Performance Through Septemeber 2014

We are having a correction in this Bull market.  I believe we are not beginning a bear market.  Meanwhile, here are the portfolio model performance #s though end of September:

US and Foreign Indexes		3 mo	1 yr	3 yr	5 yr	10 yr	2008
Stock Markets (50-40-10)		-2.3%	11.5%	17.8%	10.7%	7.6%	-39.7%
S&P 500		1.1%	19.7%	23.0%	15.7%	8.1%	-37.0%
MSCI EAFE		-5.9%	4.3%	13.7%	6.6%	6.3%	-43.4%
US OE Diversified Emg Mkts		-3.5%	4.8%	7.9%	4.3%	9.8%	-54.4%
Barclays Agg Bond--US		0.2%	4.0%	2.4%	4.1%	4.6%	5.2%
Barclays Agg Bond--Global		-3.1%	1.2%	1.2%	2.7%	4.4%	4.8%
Aggressive		-2.2%	10.7%	16.5%	10.3%	7.1%	-36.3%
90 Flex V		-2.3%	8.0%	12.9%	9.7%		-19.1%
90 Strategic II		-3.4%	7.8%	17.8%	13.3%	9.5%	-34.0%
90 Schwab index		-3.5%	8.8%	17.4%	11.2%	7.5%	-35.2%
Moderately Aggressive		-2.2%	9.8%	14.8%	9.7%	6.9%	-32.0%
80 Flex V		-2.0%	7.8%	12.3%	9.5%		-16.9%
80 Strategic II		-2.9%	7.8%	16.5%	12.4%	9.2%	-30.0%
80 Schwab index		-3.0%	8.5%	15.8%	10.6%	7.2%	-32.1%
Moderate		-2.0%	7.8%	11.3%	8.1%	6.4%	-23.1%
60 Flex V		-1.4%	7.7%	11.6%	9.5%		-13.1%
60 Strategic II		-2.2%	7.3%	13.7%	11.0%	8.5%	-23.9%
60 Schwab index		-2.0%	7.8%	12.5%	9.2%	6.3%	-25.6%
Moderately Conservative		-1.8%	5.7%	7.9%	6.5%	5.8%	-13.3%
40 Flex V		-0.8%	7.8%	11.2%	9.7%		-13.1%
40 Strategic II		-1.6%	5.9%	10.0%	8.6%	7.2%	-16.2%
40 Schwab index		-1.3%	6.5%	9.0%	7.5%	5.4%	-18.8%
Conservative		-1.6%	3.7%	4.5%	4.8%	5.1%	-2.5%
20 Flex V		-0.3%	7.4%	10.1%	9.4%		-5.2%
20 Strategic II		-1.0%	4.7%	6.8%	6.4%	6.0%	-8.1%
20 Schwab index		-0.7%	4.9%	5.5%	5.5%	4.3%	-11.7%
Asset Allocation		USA	x-USA	Bond	Cash	Other
20 Flex V		14%	5%	47%	30%	4%
20 Strategic II		11%	6%	56%	24%	3%
40 Flex V		28%	10%	30%	26%	5%
40 Strategic II		22%	12%	43%	19%	3%
60 Flex V		34%	15%	21%	24%	6%
60 Strategic II		35%	18%	30%	15%	3%
80 Flex V		45%	20%	8%	21%	7%
80 Strategic II		45%	25%	16%	12%	2%
90 Flex V		51%	22%	1%	18%	7%
90 Strategic II		50%	28%	9%	10%	3%
NOTE 1:  Past performance is no guarantee of specific future results.  This data is presented by Potomac Wealth Strategies, LLC.  This data is from Morningstar and should be accurate, but it has not been independently verified.
NOTE 2:  "Flex", "Strategic", and "Index" models are designed and managed by Potomac Wealth Strategies, LLC.  These models show track records of better returns, lower volatility, or both--or, in the case of the Index models, closest possible tracking--compared to their benchmarks and popular competitors.
NOTE 3:  "XX Schwab index" models are low-cost portfolios.  They are comprised of index funds available free of transaction charges to my clients at Schwab.  This is what many might recommend due to low-costs and portfolio efficiency.
NOTE 4:  Nothing on this blog post represents investment advice to any individual or organization.  If the information hereon is of interest to you, please contact me at Garo.Partoyan@PotomacWealthStrategies.com for a consultation.

Cash--Not Just Bill Gross--Leaves PIMCO

Friday the 29th of September will probably go down a major historical moment in the modern financial services world's history. Bill Gross resigned from PIMCO, the firm he founded in 1971 and grew into the largest bond portfolio manager in the world.  Gross not only resigned, but he moved to Janus Capital and will run a global-macro fixed income fund there.

It's probably a long story, but my take is that Gross was at odds with the people running PIMCO (which a while back was bought by Allianz, a giant insurance company based in Germany) on how to run the company.  Gross just wants to manage money.  Evidently.  He is a billionaire and 70 years-old...  not exactly in need of a new job.

Here's an article from the Wall Street Journal about cash flowing out of PIMCO's Total Return fund, which Gross has led since inception.  It's the largest mutual fund in the world.  If all investors cashed-out and the fund liquidated all holdings, bond prices would surely be affected adversely around the globe--supply and demand is a real thing, and flooding the marketplace with $200 billion in bonds would have impact.

Perhaps the main take on this for my clients is that it's an example of how I can help.  1/3 of PIMCO Total Return fund's assets are from individual investors' 401(k) plan holdings.  How many of us know what's in our 401(k)?  A lot of us, but not enough.  And even among those who know, how many were clued-in to the Gross resignation and know how to respond?  Well, that's where I believe I am extra helpful...

Bill Gross Leaves PIMCO, Starts At Janus Capital Group on 9/29/14

Bill Gross, the founder and co-head of PIMCO (perhaps the world's largest manager of bond mutual funds) has left the firm and joined Janus Capital Group.  He starts next week.

My job here is to figure out if we should continue using our PIMCO mutual funds.  I think the answer is going to be Yes, but I'm working to make sure I am still comfortable with each fund we are using.

I won't offer too much speculation here, but what I do know is that Gross founded PIMCO and built it into a huge, and hugely successful and greatly respected firm, that PIMCO is owned by Allianz (a German insurance/financial giant), and that Gross' former co-leader at PIMCO left PIMCO last year but retained a high-level position at Allianz.  Gross maybe had to jump ship from his own company, or maybe he got pushed out.  The man is a true billionnaire and so this probably is not about his compensation.  Anyway, that's where I start to get into spectulation…

PIMCO has a lot of great talent, several of the PIMCO mutual funds I use for my clients were not actually managed by Bill Gross, and we can get out of any PIMCO product we want at any time.

So, please contact me with questions, and I'll be back in touch about whether I want us to stick with our PIMCO funds.

Thank you, and happy Friday!

--Gary

Gary Partoyan

Potomac Wealth Strategies, LLC

(703) 746-8195 direct

Visit us online for helpful ideas and information!

PWS' Operations: All Good, As Usual

Potomac Wealth Strategies' operations-related systems and services are high-end and continue to be excellent.

The service my clients and I receive from Schwab Institutional remains top-notch. Safe, secure, user-friendly, reliable...  I rest easy at night knowing client assets are in good hands.

The portfolio management/billing/research/investment planning program I use from Morningstar is also great.  They regularly make improvements, sometimes with my specific suggestions.  My subscription to Morningstar Office is my largest overhead item, and it is well worth it.

Schwab and Morningstar enable me to operate on my own, but not alone. My email and web page providers, and my telecom, insurance, and tax providers are also great.

This means I can do my best for my clients with minimal operational distractions.

Thank you for your business and support.

Strategic, Flex, and Index Portfolio Performance Through 2014-08-31

Here are the latest performance #s.  The Vanguard and Fidelity strategic portfolios have been taken out, replaced by similar portfolios comprised of index mutual funds available at Schwab and free of sales loads and transaction fees.  Schwab is the custodian I use for most of my clients' accounts, and I am now showing the actual Index-based portfolios that I would offer to clients who want to use low-cost index funds.

In the most recent 1-year period, the Index fund-based models have performed best.  Over the 3-, 5-, and 10-year periods, though, the Strategic models have performed best.  The Flex models remain an excellent way to "stay invested, even if we expect or are in rough markets", and they would have fared significantly better in the market crash of 2008.

I do not favor market-timing--I prefer we remain invested using Nobel Prize-winning portfolio theory.  Some points to consider:

• Index fund-based models will have the lowest internal costs (and my advisory fee remains the same) and each should most closely track the blended benchmark assigned to it.
• Strategic models should deviate more from the benchmarks, but they have demonstrated the ability to significantly outperform over the longer time periods, and most Strategic models have done so without performing significantly worse in down markets.
• Flex models show better performance in down markets, but they tend to lag their benchmarks in strong upward-moving markets.
• Most of my clients should be using Strategic models now.  In some cases, due to risk tolerance or sensitivity to mutual funds' internal expenses, the Flex or Index models are more suitable.

US and Foreign Indexes		3 mo	1 yr	3 yr	5 yr	10 yr	2008
Stock Markets (50-40-10)		2.4%	21.2%	15.1%	12.4%	8.2%	-39.7%
S&P 500		4.7%	25.3%	20.6%	16.9%	8.4%	-37.0%
MSCI EAFE		-1.2%	16.4%	11.4%	8.2%	7.0%	-43.4%
US OE Diversified Emg Mkts		5.5%	19.2%	4.2%	7.5%	11.2%	-54.4%
Barclays Agg Bond--US		0.9%	5.7%	2.9%	4.5%	4.7%	5.2%
Barclays Agg Bond--Global		0.4%	6.2%	1.3%	3.7%	4.8%	4.8%
Aggressive		1.6%	19.0%	14.5%	11.6%	7.5%	-36.3%
90 Flex V		1.5%	14.0%	10.3%	11.3%		-19.1%
90 Strategic II		1.5%	16.4%	15.8%	15.0%	10.2%	-34.0%
90 Schwab index		2.0%	18.4%	15.3%	12.9%	8.2%	-35.2%
Moderately Aggressive		1.5%	17.5%	13.1%	10.9%	7.4%	-32.0%
80 Flex V		1.5%	13.5%	9.9%	11.0%		-16.9%
80 Strategic II		1.5%	15.3%	14.7%	14.0%	9.8%	-30.2%
80 Schwab index		2.0%	17.0%	14.0%	12.1%	7.7%	-32.1%
Moderate		1.3%	14.3%	10.2%	9.2%	6.8%	-23.1%
60 Flex V		1.5%	12.6%	9.4%	10.8%		-13.1%
60 Strategic II		1.5%	13.4%	12.3%	12.3%	9.0%	-24.2%
60 Schwab index		1.9%	14.4%	11.4%	10.4%	6.8%	-25.6%
Moderately Conservative		1.0%	11.1%	7.3%	7.4%	6.2%	-13.3%
40 Flex V		1.5%	12.0%	9.4%	10.9%		-13.1%
40 Strategic II		1.1%	10.2%	9.2%	9.6%	7.6%	-16.8%
40 Schwab index		1.6%	11.4%	8.5%	8.4%	5.7%	-18.8%
Conservative		0.8%	8.0%	4.5%	5.6%	5.4%	-2.5%
20 Flex V		1.5%	11.0%	8.6%	10.4%		-5.2%
20 Strategic II		0.9%	7.5%	6.3%	7.2%	6.2%	-9.1%
20 Schwab index		1.2%	8.3%	5.5%	6.2%	4.5%	-11.7%
Asset Allocation		USA	x-USA	Bond	Cash	Other
20 Flex V		14%	5%	48%	30%	4%
20 Strategic II		11%	6%	52%	28%	3%
40 Flex V		28%	10%	31%	26%	5%
40 Strategic II		22%	12%	40%	22%	3%
60 Flex V		34%	16%	21%	24%	6%
60 Strategic II		35%	18%	27%	17%	3%
80 Flex V		44%	20%	8%	21%	7%
80 Strategic II		45%	25%	14%	14%	3%
90 Flex V		51%	22%	1%	19%	7%
90 Strategic II		50%	29%	8%	11%	3%
NOTE 1:  Past performance is no guarantee of specific future results.  This data is presented by Potomac Wealth Strategies, LLC.  This data is from Morningstar and should be accurate, but it has not been independently verified.
NOTE 2:  "Flex", "Strategic", and "Index" models are designed and managed by Potomac Wealth Strategies, LLC.  These models show track records of better returns, lower volatility, or both--or, in the case of the Index models, closest possible tracking--compared to their benchmarks and popular competitors.
NOTE 3:  "XX Schwab index" models are low-cost portfolios.  They are comprised of index funds available free of transaction charges to my clients at Schwab.  This is what many might recommend due to low-costs and portfolio efficiency.
NOTE 4:  Nothing on this blog post represents investment advice to any individual or organization.  If the information hereon is of interest to you, please contact me at Garo.Partoyan@PotomacWealthStrategies.com for a consultation.