Index mutual funds have become one of the most popular tools in the investment community.
Not surprisingly, in Europe, passive management has had an important place within major investment strategies, to the point of replacing active management as the dominant management in some fund classes.
However, index funds have their critics, too. Those who believe that they are not a panacea and that, in certain circumstances, they can be counterproductive. There is no clear opinion on this topic, and therefore we propose to confront the two most popular positions among experts.
The point in favor of mutual funds: simplicity and low costs
The strategy of index mutual funds is to follow an index, nothing more, nothing less. For this, the managers select those assets of which it is composed, and in the same, or in similar proportions. It is a simple investment philosophy, in which the composition of the portfolio is determined by the securities that make up the index.
Its main goal is not to conquer the market, but to achieve the same profitability as it is. For many experts, it is this strategy that gives the best results and leaves the work of active fund managers in great doubt.
The reason is, in general, about 90% of mutual funds fail to beat 10-year benchmarks, and this percentage is higher as the investment horizon increases.
To this must be added the effect of commissions.
Since the manager’s job is limited to selecting already selected assets, they are easier to manage and therefore they can offer cheaper investment products.
This results in higher returns for investors, especially when compared to more expensive mutual funds.
Cons of a mutual fund index
They can’t resist bear markets
Despite the advantages of index funds, this type of product also has its critics.
The most common opinion, especially among those who own individual stocks or invest in actively managed mutual funds, is that index funds do not avoid bear markets.
However, the data does not appear to support this view.
The Vanguard principal published an analysis in 2018 on the performance of active managers during bull and bear markets, showing that less than half of active managers improved the index’s performance.
In other words, it is half the truth, because not everyone achieves this important goal.
Bad stocks are integrated into the portfolio
The second drawback of index funds is that, in the opinion of most of their critics, they combine good and bad stocks in their portfolio, and one cannot be separated from the other.
In theory, the active manager will be able to select only those good stocks. That is, those companies in which it is worth saving savings.
In theory, in some index funds, there are some companies whose growth is limited by the expectations of their future earnings.
However, the fact that they are, in general, sufficiently diverse instruments means, in practice, that the performance of some stocks is offset by others for a return that is more than acceptable in the long run.
With index funds, we assume a large opportunity cost
Supporters of active management believe that with index funds, investors lose an excellent opportunity to appreciate their wealth. Especially if they choose the right stocks or managers instead of keeping correct indexes.
But this theory collides directly with reality when comparing active management with index funds. According to a SPIVA report, compiled by S&P Dow Jones, the vast majority of actively managed funds haven’t been able to outperform their benchmark over time periods of 1, 3, 5 and 10 years.
Passive management, in practice, is also active
In practice, index funds also follow some active management.
It is still necessary to maintain an active management of product selection and the area to be indexed. In addition to scheduling periodic contributions and rebalancing if the investor so desires.
However, automation is a much simpler strategy than active management, which often depends on our intuition and can change over time depending on the events that occur in the financial markets.