Active Mismanagement: The Case for Index Funds

Indexing has suffered quite a backlash of late. From pundits proclaiming that "we're in a stock picker's market now" to columnists decrying the active management of the S&P 500, hitching your portfolio to an index seems like folly.

Actually, thinking you can consistently beat the market -- bear or bull -- is where the real folly lies.

It sure would be great if we could rely on active management to provide a little good news in this market. Unfortunately, the value-added that active managers bring -- even in this "stock-picker's" market -- is small to none.

In the first five months of 2002, the average actively managed fund underperformed the relevant Standard & Poor's index in seven of the nine Morningstar categories -- and one of the remaining two essentially tied the index. That's from a just-released study by veteran Vanguard Index fund manager Gus Sauter. (See charts below.) Keep in mind that indexing does not equate with the S&P 500 -- when a small-cap value fund beats the large cap growth-oriented S&P 500, it's irrelevant.

The study also looked at five-year performance ending May 31, 2002. In that case, indexing roundly trounced eight of the nine categories.

So much for the value-added active management brings.

Study after study has shown that index funds outperform 75% of actively managed funds over virtually any time period. But half of the remaining funds (or 12.5%) that outperform their relevant benchmark do so just as a matter of chance, according to research done by finance professor and chair of the Richard H. Driehaus Center in Behavioral Finance at Chicago's DePaul University, Werner De Bondt. Those numbers are even more compelling since they don't include the thousands of failed funds that have either folded or merged over the years.

Sources: Vanguard, Morningstar.

Sources: Vanguard, Morningstar.

So now investors are forced to pick among the 10,000 funds, 25% of which will likely beat their relevant index in any given year. That last phrase is key -- the 25% of funds that beat their benchmark don't do so every year. "There's a possibility that the next year the winning managers will outperform the benchmark by a little," says portfolio manager Steven Evanson, of Evanson Asset Management. "But over the next five years, those 'winners' will be distributed randomly over the bell curve."

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Now's when most people bring up Bill Miller. Miller, the venerable manager of the Legg Mason Value Fund, beat the S&P 500 for 11 consecutive years. (Through July 2002, the fund is trailing the S&P -- the fund is down 23.1%, the S&P 500 is down 19.9%.) Critics are quick to point out that the S&P 500, loaded with growth stocks, isn't the relevant benchmark. Even so, statistically someone is likely to beat any benchmark. "It's no more than what you'd expect from a random coin toss," says Larry Swedroe, a portfolio manager and author of Rational Investing in Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today. In other words, when you flip a coin, the odds of getting heads 10 times in a row are quite slim -- about one in 1,000. But the more people you have flipping coins, the better the odds get that at least one of them will flip 10 heads in a row. By the time you have 100,000 people flipping coins, there's a 50/50 chance that 100 of them will flip 10 heads in a row.

No one's saying that Bill Miller isn't a smart -- perhaps even brilliant -- man. But his 11-year streak isn't likely a function of brilliance alone.

Fees, Taxes and Spreads, Oh My!

When active management does beat the benchmark, it usually does so only slightly. Equity index funds lost 21.94% in the past 12 months, while actively managed equity funds just barely edged that out, losing 21.74%. Index funds returned 0.66% in the past five years, and 9.8% in the past 10. Actively managed funds, meanwhile, returned 0.65% and 8.8% in the same period, respectively, according to Morningstar.

Given how expensive active management is from an expense perspective, fund managers really need to win big to put individual fund investors even slightly ahead of the index's return. For starters, the average equity index fund has an expense ratio of 0.79% -- and exchange traded funds, or ETFs, are roughly half that (although you will have to pay a trading fee on when purchasing). The average actively managed equity fund has an expense ratio of 1.49%, according to Morningstar.

Expense ratios aren't the only aspect of active management that will eat into returns, though. The average turnover of actively managed equity funds is 118%. All that buying and selling means more internal transaction costs, greater bid/ask spreads and more capital gains generated (which, of course, means more taxes that you get slammed with -- whether or not the fund even makes money). By contrast, index funds generally have a turnover of next to nil; buying and selling occurs only when the index changes.

Small wonder the average actively managed fund lags the market by 2%.

"The problem isn't that managers are bad," says Vanguard spokesperson Brian Mattes. "But it's expensive to run those funds."

That cost, though, gets passed on to you. And in addition to the additional fees, you'll have to consistently monitor your portfolio's progress. "You can't just pick an active manager and then say 'to heck with it,'" says portfolio manager Stewart Welch III. "Active management requires a lot of time on the investor's part. And even if you think you'll enjoy it, think again. It becomes work pretty quickly."