index investing

In a recent post, I shared thoughts about why index funds and exchange-traded funds (ETFs) aren’t good investment options for most investors. The post referenced research Fidelity published titled, “Dramatic Misperception of Passive Outperformance.”

After having email and telephone conversations with a number of readers, I am now convinced that an index investing strategy is wrong for most investors. Here’s why.


Let’s start with a good example


I believe there are compelling actively managed options in nearly all asset classes. Following is an example in the mid-cap asset class.

The T. Rowe Price New Horizons Fund (PRNHX), which went through a management change on March 31, 2019, comfortably beats its benchmark on a 10-year basis (22.09% versus 17.60% through March 31, 2019). That is very significant outperformance. It’s one of the best mid-cap growth funds for that period — out of more than 500 funds. It is a five-star Morningstar rated fund.

The best passive mid-cap comparator fund is probably the Vanguard Mid-Cap Index Fund (VIMAX), which has a 10-year performance of 16.67% versus its benchmark of 16.87% through March 31, 2019.

I can’t see why anyone would throw up their hands and say, “There is just nothing better in the mid-cap space than an index fund.” Nearly 5% outperformance over 10 years is an incredibly large performance differential.

Not every active manager in the mid-cap space needs to beat its benchmark to convince me I have adequate choice with actively managed mid-cap funds.

However, just because I can find great actively managed choices in most asset classes does not mean that an index investing strategy is not appropriate for most investors. Here is a better reason.


Factor in financial advisor fees


Many Americans don’t know a lot about investments. And that’s OK. Most of us are busy with work, our families or just trying to get a little sleep. A lot of these individuals who are serious about investing end up hiring someone to provide investment advice. That’s a good decision when you don’t have the time or interest to tackle investing by yourself.

However, every financial advisor charges a fee. These fees are generally around 1% for balances less than $1 million. Extending the example above, if an advisor charging a 1% fee placed an investor in the Vanguard Mid-Cap Index Fund for the 10-year period ending March 31, 2019, that investor would have earned 15.67% (net of the 1% fee) compared with the benchmark return of 16.87%.

If the advisor had placed the investor in the T. Rowe Price New Horizons Fund for the same time period at a 1% fee, the net return to the investor would have been 21.09%. Not only does that return comfortably beat the fund’s benchmark return of 17.60%, but it is 5%+ more than the investor would have earned with an index investing strategy.


It doesn’t appear to make sense to pay for an index investing strategy


For most Americans who hire a financial advisor, an index investing strategy probably isn’t the best option. Index funds and ETFs work great in some asset classes, for those investors who are comfortable working without an advisor and for those investors comfortable living with average performance each and every year.

If you are going to pay for investment advice, it doesn’t seem to make sense to use an index investing strategy. Doing so guarantees returns, net of advisor fees, that are below average.

Why would anyone do that?


ESG exposure is another reason


Financial Advisor reports that 62% of all American workers are concerned about the environmental, social and governance (ESG) records of the companies they invest in.

As investors become more interested in including ESG factors in their decision-making process, they probably will find that an actively managed approach proves more successful. To see why, take a look at a recent article in ThinkAdvisor that outlines the difficulties the managers of ETFs have in controlling ESG exposure.


The winning formula uses a mix


Without question, the best way to build a great investment strategy is to use index options for those few asset classes that are widely covered and researched and actively managed choices for all other asset classes where inefficiencies still exist.

It is clear that passive outperforms in the large-cap asset classes, but in nearly every other investment category, active management appears to be the better choice.


This is not investment advice


None of the investment options discussed in this post should be considered as investment recommendations.

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About the author

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton is an award-winning 401(k) investment adviser with over 30 years of experience. He has consulted with many Fortune 500 companies, including: Aon Hewitt, Apple, AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Corporation, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or bob@lawtonrpc.com.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at: http://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice, and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.