Cavanaugh Capital Management (CCM) invests in a combination of equity index funds and exchange-traded funds (ETFs) as opposed to selecting active equity managers for client portfolios. This passive equity management strategy offers exposure to domestic and international, large-, mid- and small-cap companies. CCM’s equity approach combines the advantages of index funds with professional monitoring, consultation, and reporting. Below are specific reasons why CCM believes equity indexing is superior to active equity investment management.

Most mutual funds do not consistently outperform market averages.

There is a wealth of research available today proving that relatively few active investment managers consistently succeed in outperforming market indices over the long term. For those active managers that beat the index for a given time period, their past performance does not assure future outperformance. As a result, there is no way to guarantee the successful selection of those managers that will outperform in the future. Furthermore, any given active manager has as much of a chance of underperforming as they do outperforming the market. The combination of inconsistent performance and the inability to forecast with guaranteed accuracy which managers will be successful clearly outlines the risk in choosing active managers and actively-managed funds.

Indexing is inexpensive.

Typically, the combination of expense ratios and advisory fees for actively-managed mutual funds range from 1.25% to 3.00% depending on the size of the portfolio. CCM's index strategy has an average expense ratio of 0.16%. Additionally, CCM charges 0.30% in advisory fees for all equity assets under management. The combined fee (expense ratio plus management fees) is 0.46%.

Index funds are generally more tax-efficient than managed funds.

For most individuals, taxes are a significant factor in how well a portfolio actually performs. The tax-efficiency of an actively-managed fund varies dramatically. When an actively-managed fund sells a particular stock for a profit, fund shareholders incur a capital gain. These funds must distribute all capital gains annually and (taxable) investors have to pay taxes on those capital gains. Index funds usually distribute relatively little in capital gains since these funds rarely sell large blocks of a security. This allows the investor and/or advisor to better control capital gains taxes. In fact, CCM's selected blend of index funds has been over 99% tax-efficient since inception. Often the tax-inefficiency of actively-managed funds can turn a decent gross return into a poor net-of-taxes return. Unfortunately, tax-adjusted returns are rarely reported by mutual fund companies and many active investment managers, so investors may be unaware of the tax effect on their returns.

If one owns the whole market, one will get better than average market performance.

There are many index funds representing many parts of the market. A well-constructed portfolio of index funds will consist of large-cap, small-cap, and international mutual funds that reflect the entire domestic equity market as well as other markets around the world. Such a portfolio would capture the sum of all active managers’ stock picking efforts. Therefore, a portfolio of index funds would deliver the average market return. As we mentioned above, fees and taxes are typically lower in an index portfolio compared with an actively managed portfolio. Thus, after the effect of fees and taxes have been taken into account, index funds provide better than average market returns which is in contrast to most actively-managed funds over the long term.

To learn how CCM can help construct an indexed equity portfolio to suit your investment needs, please contact us for more information. (Also, see The Argument for Equity Indexing).