Monday, January 15, 2007

Index Funds — Boring! Boring!

In a recent interview on the TV program “Frontline,” John Bogle, the founder of the Vanguard Group, was asked, “What percentage of my net growth is going to fees in a 401(k) plan?” Bogle’s answer was both revealing, and probably surprisingly disappointing to participants in that type of program. “Well it’s awesome. Let me give you an example. An individual who’s 20 years old today, starting to accumulate for retirement — that person has about 45 years to go before retirement — 20 to 65 — and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that’s 65 years of investing.”

Bogle continues, “If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow to around $140,000. Now the financial system — the mutual fund system in this case — will take about 2.5 percentage points out of that return, so you’ll have a net return of 5.5 percent, and your $1,000 will grow to $30,000 to you the investor. Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return. And you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That’s a financial system that’s failing investors because of those costs for financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed.”

Using the word “fixed” in another context, the system actually is fixed — much in favor of the investment companies and even more so against the investor. Here is what the Motley Fool website says about actively managed mutual funds: “There are dozens of magazines cluttering the shelves of your local book megastore with covers proclaiming ‘The Best Mutual Funds You'll Ever Find for This Year!’, ‘Mutual Funds That Really Work in Crazy Markets Like This One!’ and other equally over-capitalized headlines. Don't pay any attention to them. Almost everything that you'll ever need to know about mutual funds is contained in these four simple words: ‘Buy an index fund.’ If that seems too simple and not sufficiently attention grabbing, try it this way: ‘BUY AN INDEX FUND!’”

It is, in a sense, difficult for me to believe that my personal attitude towards actively managed mutual funds has changed so drastically, from being a strong advocate to an equally strong antagonist. About 16 years or so ago, I started publishing a bi-monthly financial newsletter concentrating on what I called “outstanding mutual funds.” My readers were almost exclusively, what I would term as “amateur investors,” the very folks alluded to in the Motley Fool comment above — those with only a superficial knowledge of investing who did rely, at best, on recommendations from magazines and the like — and at worst, relied on mutual fund company advertising to make investment choices. That newsletter survived for some ten years, by which time I had gradually come to the realization that while there indeed were several “outstanding mutual funds” at any one given time — one month, six months, perhaps one year — funds would cycle in and out of this classification. The problem was, there was no long-term performance persistency related to any one fund, and if there were, it was impossible to predict beforehand which fund within the group would turn out to be the winner. (Incidentally, the newsletter was essentially free of charge except for mailing fees.)

Of course, 16 years ago, even ten, there was much less in the way of solid data on the long-term advantages of index funds than there is today. Even amongst professional investors and investment companies, the use of index funds as an investment vehicle was limited. Today, however, with the advent of Exchange Traded Index Funds, institutional investors, including hedge funds, vastly outnumber individual investors as users. What do they know that the average individual investor does not?

A good portion of the answer can be found in an article in The New York Times by Paul J. Lin titled “If You’re Playing ‘Beat the Benchmark’, Don’t Expect to Win.” The article opens with, “Good old-fashioned indexing — the plain-vanilla strategy of buying and holding all the stocks in a broad market benchmark like the Standard & Poor’s 500 — became popular in the late 1990s, when the major stock indexes were returning more than 20 percent a year. But investors who’ve recently turned their back on this strategy are probably regretting their decisions.” The article continues, “This year through September, only 28.5 percent of actively managed large-capitalization funds — which try to beat the market through stock selection — were able to outpace the S.& P. 500 index of large-cap stocks, according to a new study by S.& P. In the third quarter alone, it was even worse, with only one in five actively managed large-capitalization funds beating the index.”

Well, you might point out, that’s only short-term information, what about longer periods. A study by Standard & Poor found, “Over the five years through the end of the third quarter — a span that included both bull and bear markets — only 29.1 percent of large-cap funds managed to beat the S & P 500. What’s more, only 16.4 percent of mid-cap funds beat the S & P 400 index of mid-cap stocks, and 19.5 percent of small-cap funds outpaced the S & P 600 index of small-company shares.”

In fact, of the 8,000 or so mutual funds available, just 48 have beaten the S&P 500 in each of the past seven years and continue to beat it this year. That's 0.6 percent of the funds in existence. And of those 48, many are inappropriate comparisons for the S&P 500, which is a fund that invests in mostly large U.S. companies. Some of those 48 invest in overseas companies and small companies, which have done extremely well in recent years and should be compared to different benchmarks than the S&P.

Jeremy Siegal, Professor of Finance at the Wharton School, University of Pennsylvania, provides an even longer-range study of the subject. He says, “Most of us are unwilling or unable to spend all the time and effort it takes to pick individual stocks, which is why the money management business is so large. There are many individuals and organizations that, for a fee, will be happy to manage your money. Money managers are constantly hawking their portfolios, telling you that they are able to outperform the market.”

He continues, “However, data I analyzed indicates that the vast number of these mangers can't beat the market after fees are subtracted from their portfolio returns. Over the period from 1971 to 2004, the average annual return on all actively managed equity mutual funds trailed the S&P 500 Index by 87 basis points per year, and the broader-based Wilshire 5000 Index by 105 basis points a year. Over long periods, this difference in return amounted to substantial differences in wealth. This lagging performance of active managers shouldn't be a surprise; it's a matter of simple arithmetic. For every investor who succeeds in beating the market, someone else has to fall short of matching the market. When the costs (time and money) of actively picking stocks are subtracted from the outcome, those who actively engage in picking stocks must, on average, lag behind the market.”

While the S&P 500 Index is widely considered representative of the market in total, it actually reflects only the performance of the 500 stocks with the largest dollar capitalizations in the stock market. More representative would be a “total stock market” fund such as the Vanguard or Fidelity funds that covers the equivalent of the Wilshire 5000 Total Stock Market Index that includes the smaller size companies as well. In the last five years, this index, and most funds associated with it, has surpassed the performance of the S&P 500 Index funds by a significant margin. That means that it has also outperformed an even greater percentage of actively managed funds.

There may be some readers of this article who are more dedicated students of the investment market (and more specifically the mutual fund market) than the average individual investor. This (presumably) small group of readers might spend considerable time and research effort, and thus manage to outperform the indexes. However, I would bet they are few and far between. While investing in a diversified assortment of index funds (or exchange traded index funds) may be boring, and may not provide conversation for cocktail parties, you will nevertheless discover you will ultimately admire you portfolio’s performance in quiet contemplation.


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