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*Articles and content provided by SigFig Wealth Management, LLC. 

Numerous studies have shown that, over time, active investing underperforms a passive approach. There are several contributing factors, including:

So why doesn’t everyone invest passively? Taking the long-run view requires patience, and marketing is a powerful lure. Investors don’t want to match or slightly trail the returns of the market (when you factor in expenses); they want to beat the market, and that is something a passive index fund by definition cannot do. Instead, they fall for a good story: a team of smart investment professionals who have a secret strategy or the latest technology can deliver better than the market’s returns.

The reality is, there are three basic ways to make money investing in markets:

  1. Find undervalued opportunities before everyone else.
  2. Invest in the broad market over the long run, as through long-run economic gains, companies across a market deliver increasing value to their owners.
  3. Minimize costs.

Searching for undervalued assets has a strong, but illusory lure; the wealth manager just has to be smarter and faster than everyone else. The problem is that there are literally thousands of money managers, all looking for undervalued opportunities. The New York Times reported that over the six year bull market (2009 – 2015), not a single manager (out of 2,862 stock market funds) could sustain performance ranking in the top quartile of managers for all six years.

Even if a fund manager successfully tops the market for a few years, it’s very difficult to sustain that outperformance over a long period of time. Put simply: it’s extremely difficult to outsmart everyone consistently enough to beat long-run passive index performance. If it’s impossible to find a consistently excellent fund manager, why should investors pay high fees to the fund?

Index funds, on the other hand, don’t try to outsmart the market. By purchasing everything in the market index in the proportions the securities comprise the index, the fund manager aims to match the market’s performance. Some assets will increase in value, some will fall, but in sum, the index fund performance matches that of the market.

Moreover, with index funds or ETFs, investors capture value through long-run broad market gains while minimizing costs. Index funds pass on lower costs to their investors, because management costs are lower, transactions costs are less frequent, and taxes tend to be smaller.

Using an active fund manager puts higher costs on the investor: the fund manager receives a large salary, paid through the expense ratio (often 1% or more of the investor’s managed assets); fund trading costs, which may be high as the manager trades frequently in search of opportunities; and higher taxes. Even if the active manager is successful at beating the benchmark, these extra costs can often outstrip any gains for the investor.

Essentially, because they manage investor money at lower costs, index funds can increase the investor’s after-tax, net returns.

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