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The Retirement Gamble and the Triumph of the Index Fund

On April 23rd, PBS Frontline ran a fascinating documentary called “The Retirement Gamble” that took a hard look at the 401(k) workplace retirement plan system. It wasn’t a pretty picture. Among the many charges levied against the system – and in some part against the financial services industry in general – were high fees, poor disclosures, potential consumer abuse regarding product sales of annuities, and investment menus lacking low-cost index funds.

During the program, Frontline producers interviewed a number of financial company executives, none of whom came off very well.  One in particular stood out. When asked about the claim that index funds performed better on average than actively managed mutual funds, Christine Marcks, President of Prudential Retirement, responded: "Yeah, I haven't seen any research that substantiates that. I mean, it-- I don't know whether it's true or not. I honestly have not seen any research that substantiates that."[i]

Luckily, Ms. Marcks didn’t have to wait very long to be presented with that research. On May 17th, Gerard Minack, the head of Global Developed Markets for Morgan Stanley, announced his retirement. Don’t be surprised if you’ve never heard of him. But rest assured that he is a well-regarded market strategist in the investor community, many of whom eagerly anticipated his concise two-page notes that outlined his most recent thinking.

Mr. Minack saved his best note for his last. After a career spent offering thoughts on market timing and stock picking, Mr. Minack effectively gave his clients the following advice as a parting gift in his last communication: don’t try to pick stocks, don’t try to time the market, invest in a portfolio of low-cost, tax-efficient index funds. I say “effectively” because he didn’t use these exact words in his letter. Instead, in the words of Henry Blodgett on Business Insider, “…[Minack] just demonstrates conclusively why any other investment strategy is idiotic.”

This was not the first time that a long-term Wall Street investor surprised the investment world by seemingly turning his back on the typical practices of active management. In 2011, Gordon Murray, a 25-year veteran of Wall Street, found out that he had just 6 months to live. In those months, he worked with financial advisor Dan Goldie to write “The Investment Answer: Learn to Manage Your Money & Protected Your Financial Future.” Rather than advocate a strategy of actively researching stocks to buy or of buying actively managed stock funds, as might be expected of someone who worked at Goldman Sachs and Lehman Brothers, Murray advised investors to pursue a strategy of passive investing.

None of this should come as a surprise to Woodward Financial Advisors clients who remember our Investment Philosophy presentation. One of our favorite slides shows the percentage of actively managed funds that failed to beat their benchmark over the last five years, and it’s not a ringing endorsement for actively managed funds.  The common refrain among index funds proponents is that about 60% of mutual funds that invest in large US companies fail to beat their benchmark. As the chart below demonstrates (courtesy of Dimensonal Fund Advisors), over the five year period ending 2012 about 75% of actively managed US Large Cap Funds failed to beat the S&P 500 Index. That shortcoming of actively managed funds persisted in other stock categories as well.

The Failure of Active Management

Saving for retirement is hard enough without the added pressure of trying to identify which actively managed mutual fund will beat the market, an exercise where the odds clearly aren’t in your favor. The Woodward Financial Advisors approach to investments takes this to heart. Rather than trying to pick market-beating funds, we instead focus our time on building portfolios with appropriate asset allocations (e.g., the ratio of stocks to bonds) that help our clients achieve their financial goals. We try to get better returns by primarily using low-cost passively managed funds; tilting portfolios towards those segments of the market that have demonstrated above-average returns over time, such as small company and value stocks; and putting less tax-efficient investments in tax-deferred and tax-free vehicles like IRAs and Roth IRAs. That seems like much less of a gamble to us.

 

[i] Actively managed mutual funds are funds where a manager actively picks stocks or bonds that he/she thinks will perform well or tries to time the purchase or sale of investments. Alternatively, an index fund simply tracks the performance of a benchmark like the S&P 500 Index by investing in stocks in the same proportion as they are held by that index. Index funds tend to have much lower ongoing expenses than actively managed funds due to not needing to spend money on extensive research and analysis, which likely contributes to their outperformance.