Invessential

The edge individual investors have over institutions

Vineel Bhat   |   5/4/21

S&P Global’s study on the returns of actively managed funds in comparison to the S&P 500 is commonly pointed out by index fund proponents. The actively managed funds were absolutely obliterated – 92% underperforming over a 15 year time period.

Mutual Fund Performance Versus S&P 500

This is a great argument against mutual funds, but it may not apply to actively picking stocks as an individual investor. The immense size and unattractive structure of large institutions limits their possible returns, giving retail investors in edge in three categories: liquidity, time horizon, and fees. 

What are actively managed funds and the S&P 500?

A broad fund is an institution managing the capital of investors. A fund invests on behalf of their clients and make profits through commissions which are numerically represented as the expense ratio. They can be split into two categories based on style: passive and active. Passively managed funds manage capital by investing it in a predefined bucket of assets known as an “index.” On the contrary, actively managed funds hire a time of analysts and seek to beat the market in performance.

However, the long-term underperformance of these actively managed funds in comparison to the S&P 500 garners them unattractive for the vast majority of investors. The S&P 500 is a market cap-weighted index containing the top 500 companies in the US – with names like Apple, Microsoft, Amazon, Google, and Facebook collectively representing more than 20% of the whole. Index funds basing investments off of the S&P 500 are one of the most popular investments and they have historically rewarded investors handsomely.

Edge #1: Liquidity

Liquidity refers to the ease of converting an asset into cash, and its something large actively managed mutual funds don’t have much of. Funds holding tens of billions of dollars worth of assets are often limited in the purchases they can make due to liquidity concerns. Say a mutual fund is managing $50B in assets, and wants to invest 10% ($5B) into a $25B company.

This sounds fine, but the problem here is that a 25% stake is not easy to buy or sell. If a large number of investors all of a sudden started selling their stakes in the fund, the fund would have to sell the appropriate amount of the underlying assets to pay them. But if there is so much selling to a point where the institution can’t find a buyer to sell shares to, the fund fails to pay investors and goes bust. If instead the fund were investing 10% ($5B) into a $250B company, that would be a much more manageable 2% stake.

This liquidity issue thus limits institutions to either purchasing large & heavily traded assets, or purchase very small portions of smaller assets. Smaller companies tend to offer more growth potential, so the inability to invest large portions into this class of investments can hamper the returns of certain actively managed funds.

However, individual investors cease to face liquidity problems in most cases. The average retail investor manages an extremely small amount of capital in comparison to large institutions. Up to tens of millions of dollars, liquidity tends to be a non-issue.

In 1999, legendary investor Warren Buffet said “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

Edge #2: Time Horizon

Actively managed funds face pressure from clients to achieve short-term performance. Thus, mutual funds don’t keep things as simple as the S&P 500 index, which swaps out a couple companies annually but doesn’t change much other than that. This difference can be seen in the turnover rates (% of holdings replaced in a given year) of an S&P 500 index fund compared to a swath of actively managed mutual funds.

Ticker Fund Name Turnover Rate
VFIAX
Vanguard 500 Index Fund Admiral Shares
4%
TRRBX
T. Rowe Price Retirement 2020 Fund
18.8%
GAAEX
Guinness Atkinson Alternative Energy Fund
35%
FNMIX
Fidelity New Markets Income Fund
91%

The S&P 500 index fund, represented by the Vanguard 500 Index Fund Admiral Shares (VFIAX) has a small 4% turnover rate, meaning only 4% of holdings have been replaced in past year. Meanwhile all three actively managed funds: the T. Rowe Price Retirement 2020 Fund (TRBBX), Guinness Atkinson Alternative Energy Fund (GAAEX), and Fidelity New Markets Income Fund (FNMIX) come with turnover rates of 18.8%, 35%, and 91% respectively, significantly higher than that of a simple S&P 500 index fund.

On top of this, higher turnover generally means a larger tax burden. Every time you sell a security, you pay capital gains; short-term capital gains if it was held for less than a year, and a lower long-term capital gains if it was held for more than a year. Thus, frequent sell transactions in order to replace an asset lead to more capital gains distributions for investors – which can be very costly especially when they are considered short-term capital gains.

Individual investors, on the contrary, can choose to be long-term investors and avoid both loss bearing short-term bets and increased tax burdens from the sale of assets. By sticking to patient and strategic stock picking, retail investors have an advantage over short-term incentivized mutual funds.

Edge #3: Fees

All funds (with the exception of a select few) come with annual fees represented by what’s known as the expense ratio. An expense ratio of 1% means that 1% of your investment’s value will be taken as fees annually by the managing institution.

The nature of actively managed funds needing active management means additional costs such as hiring analyst and software teams. These costs are passed down to investors through higher expense ratios.

The S&P 500 index, which is the benchmark used in the S&P Global study, is not a fund managing capital, and thus has no fees that erode returns over time. In addition, S&P 500 index funds, and also passively managed funds as a whole, come with extremely small annual fees due to the low costs associated with index investing.

Ticker Fund Name Expense Ratio
VFIAX
Vanguard 500 Index Fund Admiral Shares
0.04%
TRRBX
T. Rowe Price Retirement 2020 Fund
0.57%
GAAEX
Guinness Atkinson Alternative Energy Fund
1.98%
FNMIX
Fidelity New Markets Income Fund
0.81%

The S&P 500 index fund managed by Vanguard has a miniscule expense ratio of 0.04%, barely nothing compared to the three actively managed funds TRRBX, GAAEX, and FNMIX who posted expense ratios of 0.57%, 1.98%, and 0.81% respectively.

Group Expense Ratio
Indices
0%
Average Index Fund
0.11%
Average Mutual Fund
0.84%

Benchmark indices don’t come with fees, while the average index fund charges an expense ratio of 0.11% and the average mutual fund charges an expense ratio of 0.84%. Actively managed funds (mutual funds) are thus losing about 0.84% annual return on average just from fees in comparison to any other individual stock or index. For perspective, a $10,000 investment compounding at 10% annually for 50 years would be worth $373,000 less with a 0.84% fee. All of that cash is pocketed by the institution.

Retail investors investing in individual stocks will almost never face fees in today’s age of commission-free brokers, and thus they possess an easy advantage over actively managed funds in terms of achieving returns.

Conclusion

Despite the S&P 500 index crushing a whopping 92% of actively managed funds over a 15 year time period, the individual investor’s edge in liquidity, time horizon, and fees can allow for a greater chance for beating the market.

However, its still not easy by any means for an individual investor to outperform the S&P 500 index over extended periods of time. For most investors, mirroring the US stock market by investing an an S&P 500 index fund provides a simple and appealing path to building wealth over the long-term.

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Disclaimer: Opinions not advice! I am not a registered financial advisor. All views and recommendations expressed in this article are solely my opinions and should not be considered as financial advice.