Slam-Dunk Investing Strategy Too Few Use

It's not often we're handed a slam-dunk investment strategy. But last week we got just that, as Morningstar reported that fees charged by mutual fund fees are a great predictor of whether a fund is going to be a chump or a champ. Summed up Morningstar's Russel Kinnel: "In every single time period and data point tested, low-cost funds beat high-cost funds."

Which Brings us to....the Irrefutable Case for Indexing
The Morningstar report is more marketing arsenal for low-cost index fund providers, and exchange traded funds -- at least those that provide low-cost tracking of broad-based benchmarks. In a world where it's wise to anticipate lower new normal returns, the impact of fees looms large. Make that really really large. One of the many false lessons during the market (and fund/401(k)) boom of the 1990s was that fees weren't really a big deal. When your run of the mill stock fund was gaining 20 percent a year (yes, that was normal) it was easy to look past a 1 percent or 1.5 percent expense ratio. Today, a 1 percent fee would be equivalent to 15 percent or so of the return from a new-normal market gain of 6 percent.

Yet according to the Investment Company Institute, less than 15 percent of total stock fund fund assets at the end of last year were parked in index funds:

Source: Investment Company Institute

Sure there's been a big jump since 1995, but looking just at the lost decade, it's interesting that more money hasn't drifted into low-cost index funds. Investor inertia is obviously at play here; we tend to stick with what we have. But 401(k) plan sponsors are also a factor. Participants are held captive by the funds their 401(k) sponsor (their employer) decides to offer, and plenty of 401(k)s don't include a low-cost index fund as an option. And Congress, the folks supposedly tasked with representing your best interests, refused to move forward legislation this year that would have made it mandatory for 401(k) plans to offer at least one low-cost fund. Given what the Morningstar study laid bare, it's as if Washington is uninterested in giving Americans access to a key tool that could improve their retirement portfolio.

Betting on Outliers?
The case against index funds is that a really smart manager can outperform a benchmark index. That's true. Though finding one that can do it consistently is a very tall order. And on average, most actively managed funds fall short of their benchmark:

Source: Vanguard

Yes, the above chart chart comes from Vanguard, the fund firm with the Mastiff-sized dog in the active vs. indexing fight. But just take a look at that chart -- and your long-term portfolio returns relative to an index fund -- and ask yourself if adding (more) index funds to your strategy could pay off. The odds obviously say yes. And now you've got Morningstar pretty much telling you just the same. Fees matter. A lot. That's another way of saying low-cost index funds can give your retirement portfolio an edge.

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