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The Fund Industry's Talent Problem

The past three years' storm gave large-cap fund managers a great chance to outshine index funds. But most blew it anyway.

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For years we've heard that most big-cap fund managers have a tough time beating cheap, large-cap S&P 500 index funds, which simply replicate that index. Over the past couple of years, however, active managers could've used bets on smaller stocks or even cash to top the index. Unfortunately, less than half did so in 2001 or over the past three years. And less than seven in 10 big-cap funds beat the index over the past five, 10 and 15 years, according to Chicago research house Morningstar.

So now, even some fund managers are asking tough questions. "What are you getting from your actively managed stock fund?" asked Invesco emigre and nascent hedge fund manager Jerry Paul, in a portion of last week's interview that ended up on the cutting-room floor.

The upshot: For the vast majority of us it makes sense to use an index fund tracking either the S&P 500, like the (VFINX)Vanguard 500 Index fund; or Wilshire 5000, like the (VTSMX)Vanguard Total Stock Market Index fund, as a core holding in our stock-fund portfolio. If you'd like to use ETFs, or exchange-traded-funds, check out this primer.

It's a good move to use index funds as your large-cap, core holding because the odds of us picking an actively managed fund that consistently beats those indices are slim. Let's check out the tale of the tape and then look at why so many folks with august acronyms like MBA and CFA after their names are, well, blushing.

At the start of this year, some 270 large-cap funds had been around for at least 15 years. Just 54 of those funds had matched or topped the S&P 500 over that stretch, according to Morningstar. The S&P 500 has averaged a 12.6% annual gain over the past decade. That tops the average large-cap fund, whether it uses the aggressive growth style, the bargain-hunting value style or a blend of those two approaches, according to Morningstar.


Trailing
The S&P 500 is still a brutal taskmaster
Source: Morningstar. Returns through Feb. 28.

One reason for underwhelming results is the gush of new funds. A booming economy, a bull market and the rising popularity of 401(k) plans sparked explosive growth in the fund business. Today, there are more than 4,700 stock funds out there, up from about 1,200 some 10 years earlier. Just as a the glut of new baseball teams winnowed pitching talent, the gush of new funds has probably spread the corps of skilled stock pickers pretty thin.

Index funds' low expenses give them a head start, too. Every fund's returns are calculated after their annual expenses are accounted for. Consider that the Vanguard 500 Index fund carries just a 0.18% annual expense ratio, compared with 1.44% for the average U.S. stock fund.

For a sense of how much low expenses boost your investment, compare the Vanguard 500 fund with the relatively cheap (FMAGX)Fidelity Magellan fund, which carries a 0.88% expense ratio. On a $10,000 account with identical performance, the Vanguard fund would cost you $230 over 10 years, compared with $1,202 shaved off your investment in the Fidelity fund. For the record, the Magellan fund only narrowly trails the index after fees over the past 10 years.


What Are the Odds?
The percentage of big-cap funds that top the S&P 500 over these periods
isn't flattering
One Year Five Years 10 Years 15 Years
41% 29% 23% 20%
Source: Morningstar. Data through Dec. 31, 2001.

Beyond expenses, active managers face another hurdle: an often-necessary obsession with short-term results. Because many managers' performance vs. benchmarks and their peers' is tracked and discussed quarterly, there's a natural incentive for many to juggle their portfolios to focus on "must-own" stocks and sectors that are working at a given time.

That type of short-term trading and thinking can lead to lousy long-term results. High trading or turnover often confuses motion with getting somewhere because pros and amateurs alike are usually unable to predict the market's gyrations in the short term.

It can also trigger capital gains distributions, which whittle your real returns -- how much money you have after you pay your taxes. The large-cap blend Vanguard 500 Index fund has been more tax-efficient than 93% of its peers over the past decade, according to Morningstar.

Of course, this isn't to say that actively managed funds are pointless. Small- and mid-cap funds often trounce their indices. And there are many actively managed big-cap funds that do beat the index consistently. Many are offered by quiet giant American Funds, and Ritchie Freeman's (SHRAX)Smith Barney Aggressive Growth fund has dusted the index and its peers routinely. Bill Miller, manager of the (LMVTX)Legg Mason Value Trust fund, has trounced the S&P 500 in each of the past 11 years.

Then again, there are thousands of fund managers out there, and he's the only one to do so.

Not only are the odds against you digging up a gem of a fund, the consequences can be painful if you saddle yourself with a loser. Over the past five years, the sputtering (FLRFX)Invesco Growth fund, for instance, averages a 5.7% annual loss. That trails the S&P 500 by more than 14 percentage points. On a $10,000 investment in that fund you'd be in the red, compared with a more than $6,200 gain in an S&P 500 index fund.

The bottom line is that you don't have to be an expert to see that simply picking an index fund will help you beat most of the "experts."

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to imcdonald@thestreet.com, but he cannot give specific financial advice.

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