Bob’s Journal for 7/13/23

4 Reasons Index Funds Beat Most Actively-Managed Stock Funds

A minority of actively managed stock mutual funds beat the indexes or index funds. That’s well-known.

Most people say the difference is due to the higher fees and expenses of actively managed funds. Higher costs are a factor, of course, but it’s not the only reason for the performance difference, and it might not be the most important factor.

A key reason for underperformance is the behavior of individual investors. The bulk of investors unintentionally follow a buy-high, sell-low investment strategy.

They pour money into the recent top performers, chasing investments that are making the latest headlines. Unfortunately, that’s usually when such investments are peaking. These investors sell after the prices decline.

Over time, individual investors earned an average annual return over three decades of 6.9%, while the average mutual fund earned 7.7%, according to a study reported in The Wall Street Journal. The difference is due to the buying-and-selling pattern described above.

That bad timing by individuals also reduces the returns of the mutual funds. Fund managers can’t always buy and sell stocks when they want. The funds have to buy stocks when new money flows in and have to sell stocks when investors redeem fund shares. So, the funds have to buy high and sell low, because that is what a portion of their shareholders are doing.

Another factor is that almost all the long-term returns in the indexes come from very few stocks, 4.3% of all stocks, according to one study also reported in the WSJ. Less than half of all publicly traded stocks generate positive returns during their existence.

Index funds are designed to hold all the stocks in an index while actively traded funds are paid to narrow their holdings. Missing a small number of the big long-term winners greatly diminishes a fund’s returns relative to the indexes.

The research shows that mutual funds that hold 100 or more stocks tend to outperform those holding 50 or fewer stocks, though that’s not true for all funds.

Also, an index fund continues to hold its winners, even if they become overvalued or grow to be a significant percentage of the index. Mutual fund investors often become scared and sell shares when active fund managers do that, forcing the fund managers to sell stocks they still like.

Not all actively managed mutual funds trail the indexes over the long term. Those that are competitive with the indexes tend to have a few features in common.

The successful funds have lower-than-average expenses. They’ve been successful in the past identifying some of the big winners.

The 10 largest positions in a successful fund tend to account for a high percentage of the entire fund, which matches what happens in index funds. Successful active managers also tend to trade infrequently, as revealed by the funds’ turnover ratios, which also matches what index funds do.

For examples of successful actively managed funds, take a look at two mutual funds in my True Diversification portfolio, Oakmark (OAKMX) and WCM Focused International Growth (WCMRX).

Retirement Risks of the Upper-Middle Class

The special and significant retirement risks of upper-middle class and affluent Americans often are overlooked.

There’s a lot of discussion about a “retirement crisis” in America, but those discussions focus on the risks for lower- and middle-income Americans, such as not saving enough and investing too conservatively. Households with higher incomes have different retirement risks.

The main problems for the moderately-affluent and affluent is they misidentify and misestimate their risks.

When surveyed, most in the group believe the main risks to their retirement financial security are the stock market, inflation and changes in government policies.

Those are real risks, but the main risk is longevity. Upper-income people tend to live longer than average, and that makes them more likely to outlive their resources or be hurt by inflation.

The affluent are at higher risk from longevity because they receive less of their retirement income from Social Security than people with lower incomes and net worths. The affluent are more likely to depend on savings that are invested in the markets.

Longevity is an especially important risk for the surviving spouse in a married couple. The household income declines on average by about one-third after one spouse passes away. Some expenses will decline, but generally not as much as income falls, while other expenses rise.

People who are financially comfortable and secure when they retire need to realize they still face retirement risks, and the main risk is the probability of living beyond average life expectancy and the financial consequences that could flow from that.

Why Inflation Remains Above the Fed’s Target

For about a year now, investment markets anticipated that inflation would decline quickly. The Federal Reserve was expected to be reducing interest rates by now.

All the inflation measures are below their 2022 peaks, but they still are well above the Fed’s target and declining slowly.

Many of the supply chain bottlenecks, commodity shortages and demand surges that were said to cause much of the inflation have been resolved.

The Fed increased interest rates at probably its fastest pace ever in 2022. Despite all these changes, inflation is stubbornly high.

One reason inflation remains sticky is that households and businesses are less sensitive to higher interest rates than in the past because they are carrying less debt than before the financial crisis in 2007-2009.

In addition, the labor market remains strong, despite some recent weakening. The private sector is creating new jobs, businesses report having difficulty filling open jobs with qualified people and wages are rising faster than the multi-decade average.

Workers expect inflation to continue, so they’re demanding and generally receiving compensation that largely keeps up with pay hikes.

The Fed isn’t going to be effective at bringing inflation to the target level until the labor market weakens, according to a recent paper by former Fed Chairman Ben Bernanke and former IMF chief economist Olivier Blanchard.

The economists say the 2021 surge in inflation was the result of demand and supply shocks, generally focused on commodities and goods. Those shocks, plus the government stimulus during the pandemic, resulted in overheated labor markets.

The overheated labor markets were the main reason for the strong inflation in 2022 and the persistence of high inflation into 2023. The labor market shocks are self-reenforcing and persistent.

To reduce inflation much below its recent levels, the Fed will have to bring about a better balance between the supply and demand for labor. The economists say the unemployment rate might have to rise by one full percentage point before inflation is under control.

The Data

The Consumer Price Index (CPI) increased 0.2% in June after rising 0.1% in May. That brings the 12-month increase to 3.0%, compared to 4.0% at the end of May.

The core CPI, which excludes food and energy, increased 0.2% in June, following a 0.4% increase in May. The 12-month increase for the core CPI was 4.8% at the end of June and 5.3% at the end of May.

Optimism among small business owners reached a seven-month high in June. The Small Business Optimism Index from NFIB was 91 in June, up from 89.4 in May.

All components of the survey of business owners improved. The percentage of owners reporting they are raising selling prices was the lowest since March 2021. A slightly lower percentage of owners declared inflation was their main problem.

The percentage of owners expecting sales to be higher improved, and fewer owners expected business conditions to worsen over the next six months.

Despite the improvements, the index still is below its 49-year average of 98 and has been below the average for 18 months.

The ISM Services Index was 53.9 in June, up from 50.3 in May. The index’s June level is the highest in four months.

The PMI Services Index dropped to 54.4 at the end of June from 54.9 at mid-month.

The PMI Composite Index for the economy was 53.2 at the end of June, which compares to 54.3 at the end of May and 53.0 in mid-June.

Consumer credit increased at a 1.8% annual rate in May. May had the lowest monthly increase in consumer credit since November 2020.

Revolving credit (mostly credit cards) increased at an 8.2% annual rate while nonrevolving credit (vehicle and student loans) decreased at a 0.4% annual rate.

There were 209,000 non-farm jobs created in June, according to last week’s Employment Situation reports. That’s down from 306,000 in May. The unemployment rate declined to 3.6% from 3.7% in May.

Average hourly earnings increased 0.4% in June, the same rate as in May and increased 4.4% over 12 months in both June and May.

New private sector jobs surged, according to the ADP Employment Report. There were 497,000 new private sector jobs created in June, according to the report, the most since February 2022. The leisure and hospitality sector again created the most jobs, adding 232,000 during the month.

The number of new job openings at the end of May was 9.824 million, down by 496,000 from April, according to the JOLTS (Job Openings and Labor Turnover Survey) report. Though now below 10 million, the number of job openings is well above pre-pandemic levels.

The number of quits increased by 250,000 in May to 4.02 million, the highest level since December 2022. The record number of quits was 4.5 million in November 2021.

New unemployment claims increased by 12,000 to 248,000 in the latest week.

Continuing claims, which lag a week behind new claims, decreased to 1.720 million from 1.733 million, bringing continuing claims to a new four-month low.

The Markets

The S&P 500 lost 0.30% for the week ended with Tuesday’s close. The Dow Jones Industrial Average fell 0.42%. The Russell 2000 gained 1.15%. The All-Country World Index (excluding U.S. stocks) declined 0.83%. Emerging market equities retreated 0.45%.

Long-term treasuries lost 2.31% for the week. Investment-grade bonds declined 0.84%. Treasury Inflation-Protected Securities (TIPS) fell 0.94%. High-yield bonds gained 0.09%.

In the currency arena, the U.S. dollar declined 1.13%.

Energy-based commodities increased 3.60%. Broader-based commodities rose 1.93%. Gold gained 0.58%.

Bob’s News & Updates

My latest book is “Retirement Watch: The Essential Guide to Retiring in the 2020s.” Learn more and order by clicking here and here. You can be among the first to write a review.

My previous book, “Where’s My Money: Secrets to Getting the Most out of Your Social Security,” is receiving mostly five-star reviews on Amazon for telling you clearly what your benefit options are in different situations and how to determine the best choice for you. You can find it on Amazon.com or Regnery.com.

The number of regular viewers for my Retirement Watch Spotlight Series continues to increase. You should sign up because I make in-depth presentations of key retirement finance topics. You can watch these online seminars from the comfort of your home or office at times you choose. To learn more about my new Spotlight Series, click here.

A recent five-star review of my book, “The New Rules of Retirement” on Amazon.com said, “A complete retirement guide! One of the best books on this topic!” Click for more details about the revised edition of “The New Rules of Retirement.”

If you’re interested in my books, check my Amazon.com author’s page.

I’m a senior contributor to the Forbes.com blog. You can view my contributor page here.