Systematic Investors Reap Extraordinary Returns

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Systematic Investors Reap Extraordinary Returns

The year 2013 saw the end of the long bull market in bonds that began in 1980.  Led by Fed policy, expectations of higher interest rates have driven down bond prices. 

In the face of low bond prices, individuals have increasingly turned to individual common stocks, as well as equity mutual funds and ETFs in their efforts to build wealth.  But to do so, they have had to overcome the negative psychology growing out of the financial panic of 2008.

As a result, far too many waited on the sidelines after the recovery began in March 2009, and they missed much of the enormous run-up we've seen over the past five years.  In fact, equity mutual funds only started seeing net inflows of capital in 2013 and, as of year-end, those funds still showed substantially net asset withdrawals versus 2008.

A significant percentage of investors manage their own portfolios, making trades via brokerage firms.  However, the shock of the 2008 crisis wiped out the assets and the confidence of lots of these independent investors.

So, rather than manage their own portfolios, most investors invest in traditional mutual funds or ETFs.  Today, about 20 percent of equity mutual fund assets reside in so-called "index funds," which passively mimic an index; these funds charge fees that average roughly 13 basis points.

The remaining 80 percent of equity mutual fund assets are invested in so-called "actively managed funds," which should theoretically perform better than index funds even after charging, on average, roughly 92 basis points per year in fees.

While still small, since the late '90s, the proportion of money invested in the index funds has been growing rapidly.  Index funds are popular largely because a growing share of investors consciously or unconsciously subscribes to the so-called "efficient market hypothesis," (EMH).  EMH argues that with so much attention being paid to large-cap stocks, the opportunity to outperform the market is virtually nonexistent.

When combined with advantages of lower fees and relatively infrequent trading, selecting an index fund seems like a "no-brainer" to many.  However, research and active real-world investing experience by the Trends editors confirms that the EMH is a myth that investors would do well to avoid.

Ironically, the inflow of assets to index funds, especially those that track the S&P 500, is making the market less efficient and creating even more opportunities for outperforming the indexes. 

Why?  Because index funds are mechanical constructs:  They simply purchase a capitalization-weighted basket of stocks when they receive money from investors...

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