Here’s a promising development: It looks like investors are becoming much more cost-conscious.
Over the past 10 years, 95% of the money that investors have poured into mutual funds has gone to the funds that occupy the lowest-cost quintile.
By their very nature, these funds are low cost because they simply track an index. For instance, a large-cap index fund that is linked to the Standard & Poor’s 500 holds all 500 large corporations in the benchmark. Other index funds work similarly.
An index fund is designed to do no better or worse than the benchmark that it tracks. A small-cap stock fund, for example, linked to the Russell 2000 should mimic the performance of the small-cap stocks in that benchmark.
In contrast, the portfolio managers of actively managed funds spend a great deal of money and time researching stocks and trading them. While index funds are focused on producing the benchmark averages, the active funds aim for spectacular performance returns. These funds are typically priced significantly higher than passive ones.
Despite the tremendous effort of active portfolio managers to outsmart the market and produce fat returns, studies have been showing for decades that over time active funds almost always fall short when compared to index funds.
A critical reason why passive funds enjoy a competitive advantage is because they are priced lower. And investors seem to have accepted this argument.
Here’s another stark example from the Morningstar study of how investor interest in passive investments has soared. During the past 10 years, passive stock funds attracted $671 billion in cash inflows while actively managed funds actually lost assets. Active stock funds had outflows of $731 billion.
Even among active mutual funds, investors have shown a preference for cheaper options. During the past decade, the cheapest actively managed funds received $1.07 trillion of the $1.13 trillion of net new money.
While investors are favoring lower cost funds, some funds are resisting the trend. During the past five years, more than one out of five funds raised their fees.
When evaluating mutual funds, it’s hugely important to see what fees a fund is charging. It’s best to find mutual funds with expense ratios well under 1%. Below you will see what the asset-weighted average expense ratio is for active and passive funds, as well as for all funds.