More than 4 out of 5 managers of stock mutual funds failed to beat the market last year.
It's the kind of news you might expect someone like John Bogle would jump on, and say, "Told you so." The Vanguard funds founder is an apostle of passive index investing, and the notion that investors shouldn't expect to gain an advantage paying a manager to pick stocks.
Yet Bogle didn't gloat in an interview about this week's key finding by S&P Indices: 84 percent of managed U.S. stock funds failed to beat the Standard & Poor's Composite 1500. That index of stocks small and large returned nearly 1.8 percent including dividends last year, while stock mutual funds lost an average 2.6 percent. It was the worst result in the 10 years that S&P has tracked performance of managed funds.
Noting that the 2011 result was markedly worse than any other, Bogle cuts managers some slack. "One isolated year should be ignored," he says.
After all, a single year isn't long enough to base any conclusion about how to invest over the decades that most of us will be in the market.
Instead, it's critical to consider long-term results. There, the evidence also suggests an index approach will serve most investors better than active management. One example is S&P's finding that over the past 10 years, the average percentage of managed funds underperforming in a given year was 57.
The bottom line is that the odds are stacked against anyone thinking he or she can select a managed fund that's likely to outperform a comparable index fund, year after year.
In fact, it's very unlikely a manager will outperform the market for three years in a row, according to Srikant Dash, an author of the S&P study. And it's highly unusual to achieve that feat for five years running.
Some manage to outperform over a 5-year stretch _ 38 percent did so over the period that ended in 2011, S&P found. But nearly all had a subpar year or two along the way. And five years is relatively brief, measured against a decades-long investing horizon.
Bogle, who runs Vanguard's Bogle Financial Markets Research Center, estimates there's a less than 1 percent chance that an actively managed fund will beat its market index over an average person's investing lifetime.
The main reason is the higher fees that managed funds charge compared with index funds, which seek to match the market, rather than beat it. There's no one picking stocks, so costs are lower.
Index fund expenses typically range from 0.1 to 0.5 percent, while the lowest-cost options charge just 0.06 percent _ $6 per year for every $10,000 invested.
Expenses at managed U.S. stock funds average 1.34 percent, according to Morningstar. The average expense drops to 0.74 percent when the calculation factors in that lower-cost funds tend to have more investors and assets than more expensive funds
Managed funds' higher fees are difficult to offset, even if a manager is a strong stock-picker. Fees drain returns whether a manager has a good year or a bad one. A fund's expenses are almost always a more significant factor in long-term returns than any edge a manager can achieve.
Says Bogle: "We all hear about the magic of compounded returns, and how investments can grow over the years. But so many investors forget about the tyranny of compounding costs."
Index investing, he says, "is a proven way to capture your fair share of the return the market delivers."
That's not to say an index approach can't go wrong, because some index funds are pricey. A few funds tracking the S&P 500 index assess more than 1 percent.
Yet the disappointing 2011 performance is more bad news for managers. The results are unlikely to help them stem the flow of cash out of their funds. Last year was the fifth in a row that investors have withdrawn more cash from stock mutual funds than they put in. In each of those years, exchange-traded funds have attracted more than $100 billion in new cash.
Index funds are growing as well. They held about 5 percent of stock fund assets in the mid-1990s. That grew to nearly 15 percent in 2010, according to the trade group Investment Company Institute.
Still, that means about $5 of every $6 invested is entrusted with a stock-picking manager, or a team. That suggests most investors continue to believe managers are more likely than not to earn their higher fees.
After such a tough year for managed funds, plenty of stock-pickers will come back to outperform the market in 2012.
But don't be smitten by any strong one-year results, advises Jeffrey Yale Rubin, research director with market tracker Birinyi Associates. He believes active management can add value, but says it pays to be ultra-selective.
"If you're going to go with an active manager, find one you trust, and stick with them over a long time _ not just one or two years," Rubin says. "If you don't, you end up chasing the year's hot manager. And last year's hot manager isn't likely to be this year's hot manager."
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