There is yet more evidence that index funds are the most effective tools for building and maintaining your nest egg.  A recent study by Mark Kritzman, M.I.T. instructor and president of Windham Capital Management, provided fresh evidence that after fees and taxes, it is extremely rare for an actively managed fund or hedge fund to perform better than a simple index fund.[1]

Mr. Kritzman devised a method to accurately measure the long-term impact of all the expenses associated with investing in a mutual fund or hedge fund.  He calculated average returns over a 20-year period for three hypothetical investments:  A stock index fund with an annualized return of 10%, an actively managed mutual fund with an annualized return of 13.5% and a hedge fund with an annualized return of 19%.  From these rates of return, Kritzman deducted the fees, expenses and tax costs associated with each type of fund to determine the return likely to end up in an investor’s pocket.

Mr. Kritzman found that, net of all expenses, including federal and state taxes, the index fund delivered the highest return at 8.5% per year.  The actively managed fund would have to outperform the index fund by an average of 4.3% per year just to deliver equal performance, net of all expenses.  For the hedge fund, that margin would have to be an astounding 10%.

That kind of outperformance is tough to find.  Of the 452 domestic stock funds in Morningstar’s database which have been around for 20 years, only 13 outpaced the S&P 500 index by an average of four percentage points per year or more.[2] And these winners are only visible now with the benefit of hindsight.  Identifying, in advance, the small minority of funds that will outperform during the next 20 years is like trying to find a needle in a haystack.  In his study, Mr. Kritzman wrote, “It is very hard, if not impossible, to justify active management for most taxable investors, if their goal is to grow wealth.”

1 Hulbert, Mark. “The Index Funds Win Again.” The New York Times. February 22, 2009.
2 Ibid.