Chapter 02 · Mutual funds and a personal plan
Active funds and index funds
An active fund pays a manager to choose holdings that differ from a benchmark. An index fund tries to hold the benchmark and do nothing else. This chapter is about what you are paying for in each case, and how to tell whether the active fund has actually differed.
The benchmark is the job description
Every equity fund in this comparison should name an index it is trying to beat, or, in the index fund’s case, match. The choice of benchmark is part of the honesty. A fund full of mid-sized companies that compares itself with a large-cap index will look clever in a year when mid-sized companies do well, and the comparison will be the wrong one. Read the benchmark in the scheme document and ask whether the holdings could plausibly be judged against it.
What an index fund is promising
It is promising the index return, minus costs, minus a small tracking difference. It is not promising a pleasant year. If the index falls 20%, the fund should fall about 20%. That is success, not a defect. People abandon index funds in bad years for having done the only thing they were built to do, and then buy an active fund that happened to hold more cash that quarter. Cash held by luck is not a method you can hire.
What an active fund must prove
It must own a portfolio that is genuinely different, and the difference must be worth more than the extra fee, over a period longer than one lucky year. Look at the overlap with the index. If the fund’s largest holdings are the same as the index’s largest holdings, and the weights are close, you are paying active fees for an index portfolio. Look at the tracking error, or simply at how often the yearly result differs from the index by a meaningful amount. A fund that hugs the index in down years and claims skill in up years needs a longer record before the claim is anything but a sentence.
| Question | Index fund | Active fund |
|---|---|---|
| What do I get in a bad index year? | About the index, minus a small cost. | Whatever the manager’s difference produces, which may be better or worse, after a larger cost. |
| What am I paying? | A thin expense ratio for mechanical ownership. | A thicker expense ratio for the right to differ. |
| How do I know I received it? | The tracking difference stays small. | The portfolio actually differs, and the after-fee result over many years justifies the difference. |
A fair comparison
Compare an active fund with an index fund of the same benchmark, after fees, over the longest common period you can get, and look at the bad years separately. A fund that wins by two points a year and then loses fifteen points in the single year you would have needed the money is not obviously the better tool. Also compare the active fund with other active funds only after both have been compared with the index. Ranking funds against each other without the index hides the possibility that all of them lost to it.
What to remember
- An index fund succeeds by falling when the index falls and rising when it rises, minus a small cost.
- An active fund is a purchase of difference. If the holdings match the index, you bought the index at the wrong price.
- Use the scheme’s stated benchmark, not a benchmark that flatters this year’s holdings.
- Judge after fees, over many years, with the bad years shown separately.
- One good year is an event. The fee is charged every year, including the dull ones.