@bamsphd: Thank you very much for your input. I was hoping folks like you would respond to this thread!
You are welcome.
I am a little uneasy with coin-toss analogy since it ASSUMES as a premise that active managers are dummies and have no value beyond random picks. This of course leads to the conclusion that they are not worth paying. Now, I am not saying this is an incorrect model, but it's certainly not a proof due to this circular reasoning.
I agree.
Having said this, I don't think you were trying to prove the premise itself but were just illustrating your other point on why performance in first 10 years should not matter when funds were picked already based on those years.
Correct.
Here is an issue though - unlike coid tosses, funds' performance varies a lot from year to year. In fact according to Bogle et al, usually it is the FIRST years that bring best results to the funds (which is why they then grow and survive) whereas during LATER years performance suffers. So, looking at years 1-10 and years 3-13 should eliminate those "best first years" and years 3-10 could actually be not THAT great. Still, since years 3-10 DID participate in original fund selection, I do agree they should not carry as much weight in further analysis, but I am just not so sure they should be completely discounted. So, I come to conclusion that while last 3 years should indeed carry quite a bit more weight, 10-year history (for years 3-13) still is somewhat relevant and could be quite different from history for years 1-10.
No. You are biasing your sample, then claiming your bias proves your case.
Suppose you were testing new super anti-cancer drug X against doing nothing. You accept lots of people into your trial. You decide that your doing nothing group will consist of every person in the trial who's last name begins with I. Among everyone who's last name does not begin with I, you ask "have you ever been diagnosed with cancer in the past ten years?" You eliminate from the trial everyone who answers yes. You give drug X to everyone who answers no. Three years later, you announce that in your clinical trials, people who took drug X three years ago had less cancer over the past TEN years than your control group who's names began with I.
That would be a perfectly accurate statement, but it does not tell us very much about drug X.
As an aside by the way, in your own example, it so happens that while fund A outperformed fund B during the 9 years in between (you need 11 quotes for complete 10 years, but you have 10), fund B actually outperformed fund A if you start with 3rd quote instead of 1st.
Oops. Pretend the first year both funds tied with a 0% return.
@Free to Canoe: Why would not index funds survive? I would think be definition, their value would go to 0 only if their representative market goes to 0, in which case (for diversified enough index), all the respective funds would also go to 0 (except those that might short).
The Bernie Madoff index fund. He only invests in a proprietary index of stocks which always go up.
More seriously, an index fund like any other fund can disappear without going to 0 value. If it is not making enough money, the sponsor can close it. Given that index fund costs are especially sensitive to assets under management, it is hard for a small operator to compete with Vanguard. So while the big Vanguard funds are likely to stay open, a small operator might close their fund because it was not profitable.
Even if the fund does stay open, the sponsor may change what index they follow, or the index may be redefined. Vanguard had done that to a number of the index funds I'm invested in. The changes have been evolutionary, rather than revolutionary, but they have been changes. For example, if I recall correctly, the emerging market fund did not invest in China or India when I first opened my account. They have also changed some indexes to only include the number of shares of a stock that actually trade in their calculations, which applies to some foreign companies that are majority owned by governments for example. I believe Vanguard also generally has to pay a licensing fee to use an index, so I think they will change precise indexes in part just to get a better licensing deal.
I think you bring up a
great question: why is VFINX in 56% percentile over 10 years compared to rest of funds in its category
That result is very sensitive to the start/end dates selected, and can to some extent be blamed on style-drift by other funds in the same "large blend" category. When in this case "large blend" is out performing all the other categories, you will see the "large blend" index funds beat a very high percentage of their "large blend" managed competition. However, when "large blend" lags the other categories, the index funds will beat a much lower percentage of their "large blend" competition. Basically, many "large blend" managed funds might invest 95+% in "large blend" stocks, but still have a few percent in say small-cap or emerging market stocks. That style drift can hurt or help performance depending on how the asset class is doing.
This is a problem if you are trying to carefully control your asset allocation, but otherwise it is basically a wash in my opinion.
@Yrs To Go
Now, I guess the big question is, as ERD50 pointed out, if you pick a fund where manager has been there for a long time and has a long history of both long and short-term outperformance, do you get a better than the random-pick 40% chance of outperforming the index??
That is not the question I worry about. A better than random chance of beating the index is not sufficient reason for me to select an investment, unless I can also diversify away or otherwise largely eliminate the possibility of being stuck in that bottom 25% or so for an extended period of time. First worry about the return OF ASSETS, then worry about the return ON ASSETS.
Basically, I can probably do OK if I can avoid shooting myself in the foot by investing in a stinker. How can I avoid the real stinkers?
Sure, there will always be Warren Buffets investing, as well as Bernie Madoffs, and a gazillion basically honest, but more or less average investment managers. If I could predict in advance the Warren Buffets, or the Apple, Dell, Google and Starbucks stocks, I wouldn't be investing in index funds. Regardless of how efficient the market may or may not be, I don't believe that I can use publicly available information to pick stocks or managers that will out-perform a combination of very broadly diversified index funds on an after fees, after taxes, risk adjusted basis over the multiple decades my portfolio needs to last.
Heck, "my portfolio" will probably be supporting my wife long after I'm dead. I can tell her to stick with some fixed percentage index fund allocations and to not withdraw more than 4% a year with some hope that she will do OK. However, having her watch for changes in fund managers, and pick replacement funds seems unlikely to work out well. My father solved that problem by putting my parent's money in a bank managed revocable trust. I'm just too cheap to pay the management fee such a trust would involve. I would far rather retire-early!!!!!