The Secret to Smart Investing

Your broker won’t tell you this strategy for getting better investment returns.

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Here is the secret to smart investing: Don’t buy any actively managed stock or bond mutual funds.

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A fund is considered actively managed when the fund manager attempts to beat a designated benchmark. Virtually all mutual funds recommended by brokers and most advisers are actively managed. The data is overwhelming that you would be better off in a globally diversified portfolio of low management fee stock and bond index funds, where the fund manager tracks the performance of a designated index.

Here is the information that your broker isn't likely to share with you. For the five years ending in December 2010, between 60 and 90 percent of actively managed stock mutual funds failed to beat their designated benchmark in these categories: U.S. large cap, U.S. mid cap, U.S. small cap, global, international, and emerging markets. The lone exception was international small, where 24 percent failed to beat the index.

This dismal performance is consistent with exhaustive research showing that actively managed funds, as a group, tend to underperform the market by an amount equal to their average fees and expenses. Actively managed funds are up to 500 percent more expensive than index funds. Their high cost makes it exceedingly difficult for them to capture returns comparable to low management fee stock and bond index funds.

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Actively managed bond funds fared worse, consistent with research showing this market is as efficient as stocks. There is no way to predict the movement of interest rates and bond prices. Between 56 percent and 98 percent of actively managed bond funds failed to beat their index over the past five years in the following categories: government long, government intermediate, investment grade long, investment grade intermediate, investment grade short, national municipals, and California municipals.

Your broker may tell you he is the exception and that he can pick winners, particularly in the less efficient markets, like emerging markets. There is no evidence supporting this claim. Emerging markets, like other asset classes, are random and efficient. The warning that past performance is not indicative of future performance is not just a mantra. A review of the data from 1996 to 2006 proves this point. The Russian market returned 152 percent in 1996. It lost 82 percent in 1998. Korea returned 141 percent in 1998 and lost 49 percent in 2000. Thailand returned 144 percent in 2003 before losing almost 1 percent in 2004. You get the point. There is no way to predict the next winner.

Despite the overwhelming data showing that active investors are likely to underperform the market, the daily grist of brokers and most advisers is recommending actively managed funds. The sales pitch is effective. Over 90 percent of individual stock and bond mutual fund investors purchase actively managed funds.

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The really smart money knows better. Less than 50 percent of sophisticated corporate, pension, and trust money is invested actively. You could significantly improve your returns by implementing a new plan today. Sell your actively managed stock and bond mutual funds. Become an index based investor. I tell you exactly how to accomplish this conversion and get on the road to superior returns in The Smartest Investment Book You’ll Ever Read.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.