Comparing Index Mutual Funds and Active Managers He Index Fund Recently Celebrated Its Resented in a Particular Benchmark Index
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VOLUME 32, NUMBER 28 WWW.RBJDAILY.COM OCTOBER 14, 2016 Comparing index mutual funds and active managers he index fund recently celebrated its resented in a particular benchmark index. 40th birthday. The Vanguard 500 In- The S&P 500 is made up of 500 stocks, Tdex Fund, the very first indexed mu- and Standard & Poor’s publishes the list tual fund, began on Aug. 31, 1976. That of stocks and their weights in the index. might not seem like such a big deal, but It is therefore quite simple for an index consider that during a typical 10-year pe- fund manager to purchase all of the stocks riod, roughly half of all stock mutual funds and hold them until the index changes, close their doors. Merely surviving for 40 ON INVESTING which doesn’t happen that often. Because years is quite a feat, but the fact that the Mark Armbruster the process is uncomplicated, it does not Vanguard 500 Index Fund is now among cost much to run an index fund. So, if an the largest mutual funds in the world makes also showing that the vast majority of ac- index fund rises 10 percent with the mar- it all the more impressive. tively managed funds underperform ap- ket, it might net you 9.9 percent after costs. In fact, of the 25 largest mutual funds, propriate benchmarks. When net returns are compared, clearly, the all but 10 are index funds. Of the 10 non- Twenty-five years after his Princeton the- naïve index fund is superior to the really index funds on the list, only six are actively sis, Jack Bogle was the first to marry the good active fund manager. managed. The remaining four are money academic theory with practical applica- Over time, this cost advantage com- market funds. tion, resulting in the first real-world index pounds, further handicapping active man- All of this is a testament to the vision of fund. This was a dramatic departure from agers and benefiting index funds. Several the Vanguard Group founder, John Bogle, the more traditional approach of actively studies show that over longer time periods, or Jack, as he likes to be called. managing investment portfolios. only around 15 percent of active managers Active management involves a portfolio are able to outperform appropriate bench- manager trying to select the best stocks mark indices. What’s worse is that the 15 When net returns are compared, and avoid the worst stocks in order to out- percent who are successful in any given perform a passive benchmark, such as the period are statistically unlikely to repeat the naïve index fund is S&P 500. Often, these portfolio managers that success in the subsequent period. superior to the really good active reap large salaries, as do their analysts. Ac- So, reaping outsized returns by selecting fund manager. Over time, this tive stock selection may also involve the actively managed funds has proven all but use of expensive research and technologi- impossible. With their market-meeting re- cost advantage compounds, cal tools. While experience, research and turns, index funds therefore seem like the further benefiting index funds. technology may give the manager an edge better option. in selecting stocks, the evidence shows that Index funds also generally offer a lower the edge is not large enough to overcome tax bill than actively managed portfolios. Jack wrote his Princeton thesis in 1951 the significant costs involved. This is because most index funds trade in- on the notion that most active fund man- For example, if the stock market rises frequently. Active funds, almost by defini- agers fail to outperform their benchmark by 10 percent, a really good fund manager tion, trade more aggressively and are there- indices. His research was novel at the time, might be able to generate a return of 10.5 fore more likely to incur capital gains tax- but he was not the first to notice this phe- percent before costs and fees. However, es. The money lost to taxes further erodes nomenon. a 2014 study published in the Financial your net investment return. Alfred Cowles studied active stock pick- Analysts Journal showed that total costs Despite their successful track record, in- ers in the 1920s, finding that most stock for actively managed investment portfo- dex funds are still widely maligned. Some pickers and market forecasters underper- lios average more than 2 percent annually. argue that indexing will ultimately be a form a buy-and-hold approach. Subse- Half of this is explicit management fees, victim of its own success. They suggest quently, Adam Smith’s book “Supermon- and half is implicit costs such as trading that as it gets to be too large a part of the ey” noted in 1972 that “There is no evi- commissions for stock trades in the un- market, it may stop working. However, dence that any group of funds can beat the derlying portfolio. So, even a really good there is still a long way to go before that averages.” manager who earns 10.5 percent would is a risk. As long as there are active man- Nobel Laureate Paul Samuelson, Profes- net only 8.5 percent for his/her investors agers and traders looking for bargains in sor Burton Malkiel, and investment gu- after costs. the stock market, asset prices should reflect ru Charles Ellis were all making similar An index fund, on the other hand, would fair values, providing fertile ground for observations around the same time Bogle earn the same return as the market: 10 per- low-cost index funds to continue to reap launched the first index fund. There have cent in this example. That is true because the market’s returns. been numerous academic studies since, an index fund buys all of the stocks rep- Others argue that index funds suffer the Reprinted with permission of the Rochester Business Journal. full brunt of any market declines. That is 10 percent of the total U.S. stock market. advocate for sound, ethical business prac- certainly true, but the evidence shows that The number now is closer to 30 percent. tices in the mutual fund industry and across even active managers are unable to accu- In the future, indexing is likely to continue corporate America. rately forecast coming market declines and to grow. There will certainly be periods Regardless of whether your personal in- sell out of the market in a timely fashion. when it is in vogue, or out of fashion, but vestment philosophy leans toward active or In fact, during the 2008 bear market, ac- the simple, quiet truth of low-cost, tax- indexing, lower costs and taxes are tough tive managers as a group declined in value efficient investing with top-tier returns to argue with. It is largely because of Jack more than index funds did. will continue to win investors’ confidence Bogle’s invention and tireless work that in- Indexing will continue to have its adher- over time. vesting has become so efficient over time. ents and detractors. What can’t be denied, Now at age 87, Jack Bogle is still a vocal Mark Armbruster is president of Arm- however, is that the discipline has grown defender of individual investors. The ad- bruster Capital Management Inc. He can significantly through time. Fifteen years vent of the index fund remains his crown- be reached at (585)381-4180 or marm- ago, indexed assets represented around ing achievement, but he has continued to [email protected]. Reprinted with permission of the Rochester Business Journal..