Some Index Funds Are Bad Choices for Investors

I have long been a proponent of "evidence-based" investing. For many investors, this means investing in a globally diversified portfolio of index funds with low management fees, exchange-traded funds or passively managed mutual funds.

In order to make this transition, you will need to resist the hype and marketing blitz from the purveyors' actively managed funds, where the fund manager claims to have an ability to beat a designated benchmark on a risk-adjusted basis.

The overwhelming data supporting evidence-based investing has resulted in a significant transfer of assets from actively managed funds into index-based funds. Although this is a positive development, more work needs to be done. As it stands, only a minority of individual investors select index-based funds. However, some index investors make poor choices among the many index funds available to them.

The big shift to index funds. According to a March 16 InvestmentNews article by Trevor Hunnicutt, for the 12-month period ending Feb. 28, of the 25 best-selling mutual funds and exchange-traded funds in the United States, not a single one was actively managed. Thirteen of those top 25 funds, which generated the most net inflows, were index funds managed by the Vanguard Group. Vanguard reached a staggering $3 trillion in global assets under management in September of last year, according to The Wall Street Journal.

Other fund families making the top 25 list include Blackrock Inc. and State Street Corp., both of which focus on index funds. This is a stunning reversal of fortune for actively managed funds.

Active funds are fighting back. In an effort to stanch the prodigious bleeding, actively managed funds are fighting back. According to Vincent Loporchio, a spokesman for Fidelity Investments, in an interview with InvestmentNews' Trevor Hunnicutt in a Feb. 12, 2015 article, "Fidelity records show massive profit, despite fund outflows," "You've seen investor interest in passive products and that's been a trend for a while. We believe that's a cyclical trend."

Loporchio is engaged in wishful thinking. In a similar vein, MFS Investment Management, a large and successful active fund family, recently touted its ability to beat the market by stating in an advertisement, "We believe in the power of active management." It supported this belief by adding, "There is no expertise without collaboration."

Few individual investors are equipped to provide a counterargument to these claims. My colleague, Larry Swedroe, director of research at the BAM ALLIANCE, took a hard look at the data in a recent blog post on ETF.com, "Don't Believe the Active Hype." Swedroe created a screen to evaluate only actively managed funds from MFS that had a 15-year track record, assets under management of at least $750 million, were stock funds, were either domestic or international funds and were either large-cap or small-cap funds.

Applying these criteria, he winnowed the full list of funds that MFS manages down to 11, with approximately $106 billion in assets under management. He then compared the performance of those 11 actively managed funds with funds in the same asset class managed by Dimensional Fund Advisors or DFA, a leading provider of passively managed asset class funds.

Swedroe found that six of the 11 actively managed MFS funds underperformed the comparable fund from DFA. The underperformance was not trivial. The average MFS fund underperformed the average DFA fund by 0.6 percentage points. Those results are hardly a ringing endorsement for active management.

Some index funds are poor choices. Just because you decided to become an evidence-based investor, doesn't mean you can rest on your laurels. Not all index funds are created equal. For example, the range of fees for index funds tracking the Standard & Poor's 500 index ranges from 0 percent to 5.75 percent, according to a 2015 University of Missouri study, "Diversification Bias and the Law of One Price: An Experiment on Index Mutual Funds."

Since all S&P 500 index funds seek to track the returns of that index, they all have the same expected returns. Therefore, in a rational world, you would expect investors to select the lowest-cost fund. However, the same study found large flows of funds into high-fee index funds. Various explanations have been given for this irrational behavior, including lack of financial literacy and performance-chasing.

The study, however, suggests these may not be the primary motivation for this bad investor behavior. It concludes that investors wrongly believe they are diversifying their portfolio by purchasing two or more index funds tracking the same index, even when one of them is a higher fee fund. Don't fall victim to this error, known as "diversification bias." When you invest in a fund that is tracking a certain index, there's no reason to diversify among different funds that track the same one. Fund families that tend to offer the lowest-cost index funds include Vanguard, Fidelity and Charles Schwab.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."