WSJ: Why Your Mutual Fund Will Fail, and Index Funds Rule
By SIMON CONSTABLE
The market volatility of recent days illustrates why that old mutual-fund disclaimer—“past performance is not indicative of future returns”—is more promise than warning. It’s also why most people should stick to dollar-cost averaging in index funds.
Dollar-cost averaging is simply the practice of investing a fixed amount on a regular schedule, regardless of where prices go. It’s essentially what you do in a 401(k) plan. Following this method, you tend to buy fewer shares when prices are high and more when prices are low, and are less prone to panic selling when prices dip.
Index or “passively managed” funds simply track a market index and don’t try to beat it (what active managers try to do). Most actively managed funds underperform their indexes most of the time. Most also fail to stay atop their category rankings for long. A study of 714 top-performing, active, domestic-equity funds, conducted by S&P Dow Jones Indices for The Wall Street Journal Sunday, showed that 77% of those in the top quartile as of June 2010 had dropped out in a year, and by June 2014 all had (most for poor performance, though 114 were merged with other funds or liquidated). The analysis excluded exchange-traded funds.
“It’s in every fund prospectus that past performance is not indicative of future performance,” says Richard Evans, professor of finance at the University of Virginia’s Darden Graduate School of Business. One thing that is indicative, he cautions, is poor performance: “The worst stay at the bottom.”
Active funds typically have higher fees than index funds, and these eat into returns. “At the end of the day, the most consistent thing over time is fees,” says Prof. Evans. “A fund with high fees will continue to have high fees.” That’s why experts advise against trying to pick a top-performing active fund.
But picking index funds isn’t enough; asset allocation also matters.
“It’s important to keep a balanced portfolio, and it should be designed around the needs of the client,” says Chip Addis, partner at Wayne, Pa.-based wealth management firm Addis & Hill.
Addis’s company model, tweaked for different clients, recommends putting around half of a portfolio into stocks, and the rest into bonds, cash and “alternative” investments, such as real estate and commodities.