Mutual funds have played a major role in the investment industry since their inception in the 1920s and their peak in the 1980s and 1990s. Many of us own them in our 401(k)’s or Individual Retirement Accounts (IRA's). Morningstar found that as of 2014 the majority of mutual funds are actively managed with $9.753 trillion invested in active funds versus $4.156 trillion in passive funds. Why then, have mutual fund companies seen investors pull $242.7 billion out of actively managed mutual funds this year? Where have they invested their money instead and should the everyday investor follow the crowd?
The argument comes down to the philosophical approach to investing and whether active or passive investing is more advantageous. Active management is the idea that investment professionals are capable of “beating the market” by actively choosing which stocks or bonds to buy, sell, or hold. Actively managed mutual funds do just this – they have a fund manager who selects which stocks will and will not continue achieving the objectives of the mutual fund. Alternatively, a passive approach centers on the notion that no one is inherently capable of beating the market in the long-run and it is better to take a less-involved approach, cutting out the middle men and costs along the way. Index funds demonstrate this style of investing, running on autopilot by tracking an index such as the S&P 500. This is an index that tracks 500 of the largest companies in America and includes household names like Apple, Johnson & Johnson, Disney, Amazon, and Facebook among many others. By owning one share of an S&P 500 index fund, you own a portion of each company in the index as opposed to someone actively deciding which of those 500 companies will be owned by an actively managed mutual fund.
As the statistic at the beginning of this article suggests, investors have started transitioning from the active to the passive end of the spectrum. “In 2014 US equity (stock) funds lost $98.4 billion in outflows, while passive US equity funds received $166.6. billion in inflows.” Compared to 2016 when $242.7 billion in assets were withdrawn from actively managed funds and $185.9 billion poured into mutual funds and exchange traded funds that track an index.
What caused this transition? Statistics have played a part: “A low-cost index outperforms two-thirds or more of active managers over time. And the one-third that outperform are never the same from one period to the next” says Burton Malkiel, professor of economics at Princeton University. Advancements in technology have also contributed. Since the internet has become a household staple, most people in the developed world have widespread and instant access to more information than at any other point in history. Because this information is non-discriminatory in terms of who can access it, the idea that investment professionals have quicker access or better information than the rest of the investing community is not necessarily true anymore.
So…should the everyday investor follow the crowd? Because passive investing is a relatively new phenomenon, we cannot look to history to see if moving along the active/passive spectrum is just another cyclical trend. No one has the crystal ball investors are looking for. To find out which option is best for you, consult a trusted fiduciary advisor who will put your interest above their own.
Investing in mutual funds and index funds involves risk, including possible loss of principal.