Morningstar, in a study of mutual funds identified that only about 30% of managers are able to beat the index they're matched to and that almost no one manager can consistently beat the index.
If one then extrapolates these results into a portfolio of funds with various asset classes, the probability of picking all winners in a four asset class model add up to a little more than 1%. On the flip side there's almost a 33% chance that one would pick all losers in this scenario. Clearly the odds are against an individual investor in selecting a basket of active managers.
The picture gets even grimmer if we look at the impact of taxes on active fund management returns.
Once again
Morningstar, in a study of US equity funds from December, 1994 through December, 2004 reports that for the large cap value funds, while 87% of managers underperformed the index, fully 97% did so when taking taxes into consideration. For large cap growth the percentage of
under performing managers was 54% and 80% when factoring in taxes. Only small cap growth managers tended to outperform the index with 16%
under performing and 29% when adjusted for taxes.
As this study shows, taxes have a considerable impact on investment results and over a 10 year period active managers
under perform their indexes especially when factoring in taxes.
Index funds have always provided a tax-efficient way to invest for two primary reasons. Fist, index funds experience lower turnover than most actively managed mutual funds. The second reason relates to the way index funds are bought
and sold. When investors sell shares in a traditional mutual fund, the fund company redeems the shares for cash. Any resulting capital gains are distributed on a per-share basis to the funds remaining shareholders.
