Friday, March 16, 2012

5 Facts Your Broker Won't Tell You

Many investors rely on brokers and the financial media for advice on investments. This is unfortunate, because much of the advice from these sources is demonstrably wrong and harmful to financial health. Here are five investment facts your broker will never tell you:

1. Index investments are growing. By some estimates, $2.3 trillion is invested in passive funds and exchange-traded funds. What do these investors know that your broker is keeping from you?

2. Index funds have higher expected returns. According to an article by Christopher Philips in the Journal of Indexing, index fund investors can expect to outperform a majority of higher-cost actively managed funds over similar time periods. The evidence is quite compelling. Every report prepared by Standard & Poors comparing index to actively managed funds over the past 10 years found that, during a five year market cycle, a majority of active funds in most categories failed to outperform indexes. Is your time horizon longer than five years? If so, why is your broker recommending higher cost actively managed funds that are likely to underperform comparable index funds?

3. Index funds are more tax efficient. It's not the returns of a fund that should be your sole concern. It's how much of those returns you keep, after taxes. Philips notes the typical actively managed fund distributes a whopping 50 percent of its annual price appreciation in the form of capital gains, creating tax liability for holders of its shares. In stark contrast, index funds distribute an estimated minuscule 0.5 percent as long-term gains. Turnover in a portfolio creates taxable gains. Actively managed funds have much higher turnover than index funds because actively managed funds chase returns. Index funds sell only when necessary to track the index.

4. Indexing works in both highly efficient and less efficient markets. When you mention indexing to brokers, it is much like advocating a vegetarian diet at a cattlemen's convention. The reaction can range from outrageous to simply mistaken. Brokers love to tell you how indexing might have some benefit in highly efficient markets like the U.S. government bond market. In contrast, they will note that in less efficient markets, like small-cap U.S. and high yield bond funds, active managers strut their stuff and outperform. The data is to the contrary, but don't expect them to show it to you. Philips looked at 15 years of data as of December 31, 2011. Active managers in both small-cap U.S. equity and high-yield U.S. bond funds underperformed significantly.

5. Index funds outperform in bull and bear markets. You may have heard this statement (or some variant): In bear markets, active fund managers shine because they can shift assets in and out of the market and minimize losses. It's bunk. Phillips calculated the percentage of active managers who outperformed the market during various bull and bear markets. He found that in four of the seven bear markets since January 1973, the average actively managed mutual fund underperformed the index. It's worse in bull markets. Active fund managers underperformed in seven of the eight bull markets examined.

If you knew these facts, you would not invest in actively managed funds. Now you know.

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