In an environment where the stock market recovers and the credit crisis is in the rearview mirror, will your investments recover with the stock market, lag behind or remain at today’s levels? The investment tool you are using will make the difference.

Each quarter, Standard and Poors comes out with a report detailing how mutual funds performed compared to passive investments or indexes. Remember, ETFs are investment products that track indexes and are comparable with them. This report, the Standard and Poor’s Passive Verses Active Scorecard or SPIVA Scorecard, takes a unique view of how mutual funds performed verses indexes. The scorecard weights its category averages of mutual funds by average investor experience, or simply, how much money investors as a whole have in the funds, with more money invested giving the fund a higher weighting in the category average. This is unique in that it details how the average person is invested in America. From this we can show if the average investor would be better served elsewhere.

Below is a 5 year comparison of the active manager’s annual return verses a comparable index. The active management’s numbers are averaged by S&P using the asset weighted approach to analyze where the average investor’s assets where located.

In all three broad US categories, passive benchmarks outperform active benchmarks. In a further breakdown of style (Growth and Value), international, and real estate category (which includes renovation companies and home improvement companies that cater to air filters, landscaping, etc) averages verses benchmarks we can see that in 2008 and the 5 years prior to the end of 2008, passive benchmarks outperformed the highly paid, professional money managers, who, for the most part, spent their careers specializing in investing. The table below shows the fund category, comparable benchmark, and the percentage of funds that did not beat their benchmarks over the time periods. The fund averages are equally weighted and all information has been gathered from the latest SPIVA Scorecard.

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active-fund-underperformance

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Mutual funds have difficulties outperforming benchmarks. This happens for several reasons and goes against general conceptions of the industry. These facts uncover a common myth in the investment industry, that mutual funds, with professional oversight, can sidestep obvious market downturns. This is apparently not true for the majority of mutual funds.

By their nature, mutual funds hold some amount of cash for withdrawals, which in market downturns, would slightly soften the funds’ performance on the downside; however on the whole, the majority of mutual funds in most categories did not demonstrate any softening effect during the most recent downturn.

The sad part about this picture is that investors do not receive the quality investment advice they need.

A Winning Strategy: Making the Switch

As explained, the majority of mutual funds will not allow an investor to win even with a great diversification and asset allocation strategy. Exchange Traded Funds, ETFs, can update your old investment toolbox and allow for a winning strategy to be effective.

For example, the S&P 500 which outperformed 71.9% of large cap mutual funds from 2004-2008, can be cheaply and effectively utilized through either of two ETFs.  Below is a chart of the iShares S&P 500 Index (IVV) and the first and largest ETF, the SPDR S&P 500 ETF (SPY) graphed against the S&P 500 Index.

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Notice that the two ETFs track the index very closely.  This is just one example showing the importance of having an effective investing tool.  A mutual fund that underperforms and is very costly to own will drag performance down over time and as the economy recovers, there is no guarantee that the mutual fund will recover with it.

With ETFs, where an investor held a large cap value index, switching over to a similar ETF like iShares S&P 500 Value Index Fund (IVE) can be a way to keep the same investor strategy or asset allocation but update the tool.  This is a common misconception of what really drives returns.  It is typically not a manager that drives a fund’s return but the strategy of the fund like large cap value or large cap core, that drives the return and the investment tool or which fund you choose allows you to capture that return characteristic.

ETFs are a cheap and highly efficient way to build a highly diversified portfolio based on your long term investment strategy.  For nearly every asset class and mutual fund category there is a comparable ETF that would allow the investor to access an asset class’ complete return characteristics.

– Casey Smith is the President of Wiser Wealth Management