Q: Are index funds or actively managed mutual funds the smarter choice?
There isn’t an easy answer, but here are the key differences and some facts that could help you make your decision. In general, however, I think index funds are the best investment for most people who don’t have the time or desire to research individual stocks.
The key advantages of index fund investing are cost and the guarantee of matching the market’s performance.
Because the fund’s managers don’t actually need to do any stock picking, index funds tend to have significantly lower fees. For example, the average actively managed large-cap stock fund has an expense ratio of 1.25% while the average S&P 500 index fund charges a minuscule 0.15%. Over time, this difference can really add up.
Image source: Getty Images.
Diamond Hill Investment Group (NASDAQ: DHIL) reported third-quarter results on Oct. 26. The asset management company saw its advisory revenue bolstered by investment income, which, along with gains related to the sale of a subsidiary, led to a sharp increase in profits.
Diamond Hill Investment Group results: The raw numbers
Earnings per share
Data source: Diamond Hill Investment Group Q3 2016 earnings press release . YOY = year over year.
What happened with Diamond Hill Investment Group this quarter?
Diamond Hill experienced net cash outflows of $528 million during the third quarter. However, in terms of assets under management, investment gains of more than $1 billion more than offset these outflows, helping its AUM grow to nearly $18.1 billion as of Sept. 30, 2016, up from $15.9 billion at the end of Q3 2015.
Its higher AUM boosted investment advisory revenue by 7% year over year to $29.5 million. Mutual fund administration revenue, however, fell 13% to $3.4 million due primarily to Diamond Hill’s recent sale of its Beacon Hill Fund Services business. In all, total revenue rose 5% to $32.9 million.
And while they’ll never beat the market’s performance, by definition index funds guarantee that you’ll do as well as the market over time. The S&P 500 has historically generated annual returns of nearly 10%, so this can effectively build wealth over time, especially with the low fees.
On the other hand, actively managed mutual funds have the chance of beating the market, but their fees put them at an inherent disadvantage. As legendary investor Warren Buffett has explained it, if half of fund managers beat the market and half don’t, when you account for the fees, the average fund will underperform.
The statistics confirm this. Just 1-in-3 active managers of large-cap funds were able to beat the S&P 500 in a recent year, and the figures were even worse for mid-cap and small-cap fund managers. And over the last 15-year period, a staggering 92% of large-cap managers underperformed the market.
That said, if a fund has a particularly strong and sustained record of performance, it could be worth the additional fee. For the most part, however, index funds are the better bet.
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