Do you need an actively managed fund?

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Elliot Raphaelson

Not all experts agree whether actively managed funds can outperform index funds. Some do in the short term, but it is certainly not easy to select actively managed funds that will outperform index funds in the long term.

An index fund manager buys all of the securities of a specific index, such as the S&P 500, or at least a representative sample. The objective is to track the index’ performance as closely as possible.

Index funds are commonly described as “passively managed.” An actively managed fund, by contrast, is one in which the manager selects individual securities in an effort to outperform specific indexes.

One of the most important factors to consider is the annual cost associated with an actively managed fund you are considering in comparison to the annual cost of the indexed mutual fund or exchange-traded fund (ETF) you are comparing it to.

Morningstar has done extensive research in this field and has pointed out that the annual cost of the fund is one of the best predictors of long-term performance.

A tale of two funds

What follows is a comparison between the Vanguard Total Stock Market Index Fund (VTSAX) and the Dodge & Cox Stock Fund (DODGX).

The Dodge & Cox fund is in the top performance echelon for long-term value funds. Morningstar gives it a four-star rating; in terms of trailing total returns, it’s ranked No. 1 in three-year and 15-year returns. It has fairly consistently outperformed the S&P 500. If you chose this as your single managed stock fund, you can congratulate yourself for being an astute fund picker.

The Vanguard Total Stock Fund is also an excellent fund. It’s a standard index fund of a large, well-known company. If you buy it, you won’t exactly impress your friends for your originality (it has assets more than six times larger than the Dodge & Cox fund). However, you will be just as pleased by its performance.

Let’s compare.

Dodge & Cox Stock Fund (DODGX)

Expense Ratio: 0.52

Trailing total returns (according to Morningstar)

1-year: 13.47 percent

3-year: 24.93 percent

5-year: 15.31 percent

10-year: 7.48 percent

Vanguard Total Stock Market Index Fund (VTSAX)

Expense Ratio: 0.05

Trailing total returns (according to Morningstar)

1-year: 14.61 percent

3-year: 21.32 percent

5-year: 15.66 percent

10-year: 8.32 percent

An investment of $10,000 made 10 years ago would be worth $20,576.80 if you chose Dodge & Cox. It would be worth $22,233.13 if you chose the Vanguard fund. (Those figures are from Morningstar.)

Expenses make a difference

There is no question that the Dodge & Cox fund is an excellent fund and is well managed. However, no actively managed fund can compete with index funds on a cost basis.

Note the difference in expense ratios: 0.52 for the Dodge & Cox fund vs. 0.05 for the Vanguard fund. On a long-term basis, it becomes very difficult for any well-managed active fund to outperform an index fund in the same category.

Index funds also have one additional advantage over actively managed funds — savings on income taxes. There will be more “turnover” in actively managed funds than there would be with index funds. For any investments other than retirement accounts, you will have more of a tax liability with actively managed funds because you will incur more capital gains taxes.

In my opinion, most investors will be better off in the long-run by investing the majority of their common stock investments in index funds. You can still diversify within index funds, investing in small-cap, mid-cap, large-cap, value and other types of index funds. You can do this with both mutual funds and ETFs, but you should limit your investments to those funds with the lowest expense ratios.

Elliot Raphaelson welcomes your questions and comments at elliotraph@gmail.com.

© 2014 Elliot Raphaelson. Distributed by Tribune Content Agency, LLC.