The Stampede To Index Funds

I would like to use this article from Business Week (April 1, 1996, pp. 78-9) to illustrate two points:

Definition of Index Funds: These are managed portfolios of equities that try to achieve the same performance as that of a market benchmark, say, the S&P 500 index. The simplest way to achieve this objective is obviously to hold all the stocks in the index. Thus, it is a passive, buy-and-hold strategy. On the other hand, the investment objective of non-index mutual funds is to "beat" a benchmark through active selection of stock and/or successful forecasting of swings in prices and buying/selling accordingly.

The size of index equity funds has reached $400 billion. Not surprising given the performance of the average managed fund.

	S&P 500	Managers Beating The S&P 500
	Total Return	Mutual Funds	Institutional Funds
1995	37.6%	8%	29%
1993-95	15.3	21	32
1991-95	16.6	26	47
1986-95	14.9	14	33
Notes. Includes reinvestment of dividends and capital gains. Multiyear periods are average annual returns. Mutual funds are U.S. diversified equity funds, after expenses, but before sales charges. Institutional fund returns are before expenses.

The table above underscores the inability of most mutual funds to beat/outperform the S&P 500 index. Thus, you would have been better off investing passively in a well-diversified equity portfolio over 1-year, 3-year, 5-year, and 10-year investment horizons than investing in an average mutual fund.

Of course, your friend could be bragging about how smart he/she is in picking "great" mutual funds. Obviously a number of mutual funds did outperform the index, however, other studies have shown that there isn’t a systematic and predictable formula for choosing successful mutual funds. Thus, most likely your friend was lucky!

Q Look at the notes at the bottom of the table. Don’t they make the argument in favor of the EMH even stronger?

Yes. The notes indicate that the above returns were calculated before subtracting any "sales charges" in the case of mutual funds, and "expenses" in the latter case. So if you include sales charges - also referred to as "loads" - there would most likely be even fewer funds that "beat" the S&P 500.

(a) Index mutual funds typically have zero "sales charges." In all fairness, I like to note that there is a trend in the industry whereby you can invest in a wide range of "no load" mutual funds through the major providers such as Charles Schwab, Fidelity Investments, and Vanguard. Note that "loads" can be as high as 8% of an investor’s capital.

(b) Funds have to charge for their services. They are referred to as "management fees." These fees are much smaller for index funds. "Big pension funds pay 1 to 2 basis points a year, or 0.01% to 0.02%, of assets as management fee vs. 0.4% to 0.5% for active management, according to the article. For an individual, on the other hand, management fees in an index fund is about .45% compared to 1.5-2.0% for a typical mutual fund.

(c) As noted in the article, because index mutual funds don’t actively buy and sell stocks, there are few if any taxable capital-gains distributions to fund investors. Thus, taxes are deferred until the investor cashes out of the mutual fund.

Thus, if you include management fees, sales charges, and taxes, your bragging friend might not be doing so well. Moreover, the odds are even less favorable to active management when considered over long-term investment horizons.