No matter what age you are or which period you are tracking, ten years is a long time! As it is, ten years ago today was when I started tracking my 401(k) because the markets were about as low as I could imagine them, and I was so curious what was next. As it turned out, the markets would bottom out within a month and then begin on a record long bull run that did not end until December 2018. Basically, it was a 10-year period in which it was much harder to lose money than make money!
Regardless, a lot happened in that time: I quit my job, I went to school, I attempted to re-career from the finance industry into the legal field, I ended up in the legal department of a finance company, and I had to modify my 401(k) investments when my provider changed the investment options. As of today, I am also halfway through a M.B.A. program! Having worked in finance for 10 years though, this program feels more like it is papering down my knowledge base than brand new studies, which is not a bad thing.
My current ECON class textbook had an interesting take on active management versus indexing:
"Mutual fund investors have a choice between putting their money into actively managed mutual funds or into passively managed index funds. Actively managed funds constantly buy and sell assets in an attempt to build portfolios that will generate average expected rates of return that are higher than those of other portfolios possessing a similar level of risk. In terms of Figure 35.3, they try to construct portfolios similar to point A, which has the same level of risk as portfolio B but a much higher average expected rate of return. By contrast, the portfolios of index funds simply mimic the assets that are included in their underlying indexes and make no attempt whatsoever to generate higher returns than other portfolios having similar levels of risk.
"As a result, expecting actively managed funds to generate higher rates of return than index funds would seem only natural. Surprisingly, however, the exact opposite actually holds true. Once costs are taken into account, the average returns generated by index funds trounce those generated by actively managed funds by well over 1 percent per year. Now, 1 percent per year may not sound like a lot, but the compound interest formula of equation 1 shows that $10,000 growing for 30 years at 10 percent per year becomes $170,449.40, whereas that same amount of money growing at 11 percent for 30 years becomes $220,892.30. For anyone saving for retirement, an extra 1 percent per year is a very big deal.
"Why do actively managed funds do so much worse than index funds? The answer is twofold. First, arbitrage makes it virtually impossible for actively managed funds to select portfolios that will do any better than index funds that have similar levels of risk. As a result, before taking costs into account, actively managed funds and index funds produce very similar returns. Second, actively managed funds charge their investors much higher fees than do passively managed funds, so that, after taking costs into account, actively managed funds do worse by about 1 percent per year.
"Let us discuss each of these factors in more detail. The reason that actively managed funds cannot do better than index funds before taking costs into account has to do with the power of arbitrage to ensure that investments having equal levels of risk also have equal average expected rates of return. As we explained above with respect to Figure 35.3, assets and portfolios that deviate from the Security Market Line (SML) are very quickly forced back onto the SML by arbitrage, so that assets and portfolios with equal levels of risk have equal average expected rates of return. This implies that index funds and actively managed funds with equal levels of risk will end up with identical average expected rates of return despite the best efforts of actively managed funds to produce superior returns.
"The reason actively managed funds charge much higher fees than index funds is because they run up much higher costs while trying to produce superior returns. Not only do they have to pay large salaries to professional fund managers, but they also have to pay for the massive amounts of trading that those managers engage in as they buy and sell assets in their quest to produce superior returns. The costs of running an index fund are, by contrast, very small since changes are made to an index fund’s portfolio only on the rare occasions when the fund’s underlying index changes. As a result, trading costs are low and there is no need to pay for a professional manager. The overall result is that while the largest and most popular index fund currently charges its investors only 0.18 percent per year for its services, the typical actively managed fund charges more than 1.5 percent per year.
"So why are actively managed funds still in business? The answer may well be that index funds are boring. Because they are set up to mimic indexes that are in turn designed to show what average performance levels are, index funds are by definition stuck with average rates of return and absolutely no chance to exceed average rates of return. For investors who want to try to beat the average, actively managed funds are the only way to go."
Fairly rousing endorsement for what I have been following in the past 10+ years. Of course, the recurring question has been whether rebalancing quarterly has been too often, but this past quarter is a good example of its merits. On November 10, 2018, we had no idea what the next three months would be like! The markets were shaky, but a Christmas Eve Massacre saw the Dow plummet 650 points.
There were two ways to go: one, panic and make immediate changes or two, stay the course. In this case, staying my course involved weathering the fall for the next two months and then buying into the depleted markets by moving other assets that might have appreciated in that time. As it turned out, the market has recovered most of its losses since its recent lows, so staying the course was the best choice.
Therefore, my move for this rebalance was minor (as the past several have been). Instead of taking money from the stock funds though, this time I put money into those stock funds. Specifically, I took 1.5% from my International Stock Index Fund, 4.7% from my Bond Market Index Fund, and 4% from my International Bond Fund, and I placed that amount into my PRIMECAP Fund (53%) and my Total Stock Market Index Fund (47%). Nothing close to approaching 10%, but just like in baseball, winning in wealth creation is more about the consistent singles and doubles than the occasional home runs.
