What is the Best Way to Invest Your Money?

What’s the best way to invest your money?

I’m not talking about whether to invest in stocks or bonds or real estate.

I assume you’ve already decided on a diversified portfolio of mutual funds or ETFs, most likely covering all three of those popular asset classes.

The question is: What kind of funds should you choose?

Index funds that match the performance of the market, good or bad?

Or actively managed funds that try to beat the market by choosing the best stocks or bonds (security selection) or buying and selling at the right time (market timing)?

Seems like a silly question. Who wouldn’t want to beat the market? The problem is, beating the market is hard.

We’ve known this for decades: most actively managed funds underperform the equivalent index funds. Standard & Poors publishes a free study on the topic, called SPIVA, every year.

But most investors don’t choose a single fund. They invest in multiple funds: a bond fund, a US stock fund, an international stock fund, and perhaps other funds such as municipal bonds or real estate.

Rick Ferri, CFA, a financial advisor with Portfolio Solutions, noticed there was little research comparing portfolios of actively managed funds with index portfolios.

So Ferri teamed up with Alex Benke, CFP, of Betterment.com to analyze publicly available data and answer the question in a new white paper: If we build a whole portfolio of index funds, do they maintain their advantage? Or can we beat the market by combining actively managed funds into a portfolio?

(Note: both Portfolio Solutions and Betterment get paid to design and manage index fund portfolios.)

The study

Ferri and Benke used the CRSP database of historical mutual fund returns.

Their study ignored the effects of sales loads and taxes, which biased the results against index funds, which tend not to carry sales loads and are more tax-efficient.

The authors started with a simple portfolio consisting of three funds: a US stock fund, an international stock fund, and a US bond fund.

They ran 5000 trials comparing the performance of this portfolio over a 16-year period (1997-2012) to equivalent sets of actively managed funds from various providers available during the same period.

The result: the index fund portfolio beat the active portfolio 82.9% of the time. Perhaps more important, the active portfolios that outperformed didn’t do so by very much: 0.52% on average.

The active portfolios that underperformed, however, lost out by an average -1.25%.

Next, the authors looked at portfolios covering more asset classes, adding (in one example) real estate and short-term bonds. Now, over a 10 year period, the index portfolio won 87.8% of the time.

Finally, they noted that people who invest using active funds often like to diversify.

Instead of buying one active stock fund and putting all their beans in the care of one manager, they buy two or three funds in each category.

Well, bad move. Diversifying among active funds makes it even less likely that you’ll outperform an index portfolio.

“It was not our intent to suggest or prove that active management doesn’t work or to say that no active management strategy can beat a specific index benchmark,” write Ferri and Benke. “We know that’s not true. It is possible to outperform a portfolio of index funds using actively managed funds as our analysis shows; it is just not probable.”

What does it all mean?

The most obvious criticism of the study is that Ferri and Benke chose their active funds randomly, but real investors don’t. They try to choose the best funds, and they use many filters to identify them.

Among the popular data points:

• Length of manager tenure
• Recommendation from a friend, newsletter, or article
• Fund holdings
• Expense ratio

None of these measures is strongly associated with future outperformance, not even expense ratio.

“A common belief in the investment community is that low-fee actively managed fund portfolios have a meaningfully higher chance for outperforming an all index fund portfolio,” write the authors. “We find no evidence to support this view.”

Most investors don’t look at any of these things, anyway. They look at past performance.

And here the evidence is overwhelmingly clear:

• Actively managed funds that have outperformed in the past are likely to underperform in the future
• Actively managed funds that have underperformed in the past are also likely to underperform in the future

This isn’t a result from Ferri and Benke’s paper, although they do note that “[E]ven the most prescient investor cannot predict which funds will outperform and over what period.”

We have plenty of evidence from SPIVA to back up that statement.

SPIVA’s 2012 Persistence Scorecard looked at whether good funds stayed good over time. The report is full of data, but here’s a choice nugget.

Let’s say you invested in an active stock fund in September 2008, and you chose a good fund, one in the top 25% based on the previous 12 months’ performance.

What are the odds that your chosen fund would stay in the top 25% each year for the following four years, ending in September 2012?

The answer is 0.18%. No chance.

If you picked a fund in the top half of performers, it had less than a 5% chance of staying in the top half. To pick a winning active fund, you need incredible luck or astonishing skill.

Markets are unpredictable, and you can’t guarantee great investment performance by choosing index funds. But you can (nearly) guarantee underperformance by choosing active funds.

Or, as author William Bernstein put it last year, “The debate between active and passive management is like the debate between astrology and astronomy.”

Matthew Amster-Burton is a personal finance columnist at Mint.com. His new book, Pretty Good Number One: An American Family Eats Tokyo, is available now. Find him on Twitter @Mint_Mamster.