Bernie Madoff is warning regular investors not to let Wall Street scam them like he did. His advice: Use index funds. In a recent interview with MarketWatch, Madoff was asked where the safest place is to invest money with the least amount of risk for fraud. His answer:
“The best chance for the average investor is to put money in an index fund. There are lower commission rates and more professional management with these types of firms. It’s the safest and least likely place to get scammed.”
Madoff as a dispenser of investing wisdom is rich. That said, he has nothing to sell anymore and no good reason to lie as he is going to die in prison serving a 150-year sentence. And who has a better grasp on how the financial industry exploits investors?
Madoff's an unlikely messenger with the right message for the vast majority of investors. Index mutual funds and exchange-traded funds are subject to much more rigorous oversight by the Securities and Exchange Commission than are hedge funds. Index funds also have a much better record on insider trading and fraud. When is the last time an index fund executive was charged with a crime, much less gone to jail?
The Index Edge
The more relevant debate for most retail investors is between index funds and actively managed funds, since both are heavily regulated and diversified.
Index funds start out with an edge, since they have much lower expense ratios than actively managed mutual funds. According to a 2012 report from the Investment Company Institute, the average asset-weighted expense ratio of a mutual fund was .92 percent versus .13 percent for an index fund. That’s more money working for the investor in the market. On a $100,000 investment that adds up to $790 more per year invested in the market with the index fund. Over decades that can compound into a far greater sum.
Actively managed funds typically also have higher turnover -- a term for the percentage of a fund’s holdings that change every year. For example, the actively managed Fidelity Magellan Fund (FMAGX) has a turnover of 88 percent, while the Vanguard 500 Index Fund (VFINX) has a turnover of 3 percent.
Higher turnover creates all kinds of extra costs to fund shareholders. They include trading commissions, taxable capital gains and costs from "trading impact" -- the price a fund gets when buying or selling as a result of their trades moving market prices up or down. All of these things are "hidden fees" paid for by investors but not included in the expense ratio.
Higher fees and turnover are the primary reasons why the majority of active managers cannot beat their benchmark, a reality that's well documented in the S&P Indices Versus Active Funds (SPIVA) Scorecard. The yearend 2012 scorecard shows that in nearly every category active managers lagged their benchmarks.
Index funds also get better with age, as highlighted in a recent Forbes article. According to a study cited in the article, roughly 40 percent of active equity mutual funds beat their benchmark over one year, 34 percent over five years, 27 percent over 10 years and 14 percent over 30 years.
A prime example of this is how the Fidelity Magellan Fund is up 24.5 percent in the past year versus 25.1 percent for the Vanguard 500 Index Fund -- but when you go back 10 years FMAGX is up 60.4 percent while VFINX returned 105.2 percent. If you go back 20 years the gap gets wider, with FMAGX returning 258 percent to VFINX's 425.6 percent. The reason for this is fees, turnover and the fact that it is just extremely difficult, if not impossible, to consistently beat the market as a stockpicker.
Index mutual funds and ETFs are regulated, diversified, low-cost and better performers than their actively managed peers. So bottom line investing in an index mutual fund or ETF is the safest way to invest for the average investor. As one person posting on the online Bogleheads.org forum put it: "When the academics and the crooks both agree, you are probably onto something good."