Index funds beat most active funds

[JustCurious]

I had an email exchange today with someone whom I recently met who is an "associate vice president" with a major national brokerage house. I showed him the recent study by Standard and Poor's which says that equity indices have outperformed active funds over the last 5 years (go to the link below to "indices" section of the news)

http://www2.standardandpoors.com/servlet/Satellite?pagename=sp/Page/PressMainPg&r=1&l=EN

He first diputed the validity of that study because he argued that only focusing on the third quarter was not enough for a meaningful comparison. I agreed with that, but pointed out that the study looked at 5 year returns as well.

He then stated that an investor in an SP 500 fund would have lost money since 2000 (he cited to the fact that the current SP500 index is lower than the March 2000 index level). I pointed out to him that the index does not account for reinvested dividends, and if he looks at VFINX (vanguard's 500 index fund), the 5 year performance is 6.8 percent, and that the average investor would have gotten respectable returns, far from losing money! I also pointed out that the total stock market index fund gained over 8 percent over the same period, and he simply ignored that.

He then argued that average annual returns are "meaningless" (yes he used that word), but he did not provide a better way to gauge performance. I then pointed out to him that everyone in the financial industry, including his own firm, extensively cites to average annual returns when they market their funds, and that surely they don't rely on "meaningless numbers."? He ignored that.

He then argued that the average investor can't ride out the market's bear markets (a valid point), but i pointed out that was not a criticism of index investing, but of investor ignorance. An investor can have an advisor who recommends index investing AND not bailing out of their asset allocation.

He then argued that because 25 percent of large cap equity funds beat their indexes, this was proof that you should select those actively managed funds to beat the index. I responded that it was very difficult, if not impossible, to know which of the actively managed funds would beat the index in the future (as opposed to what he did, which was cherry pick those in the past which did beat the index).

The bottom line is that he refused to even concede that index investing was a good idea in the face of clear evidence supporting the fact that index funds beat most actively managed funds. It reminds me of the old saying that you can't convince someone of something if their livelihood depends on not being convinced.

 

[mathjak107]

ITS a difficult thing to compare because of time frames and the funds involved. I can tell you i have beat the indexes over the last 20 years with my actively managed funds and most important i did it with less overall risk than the s&p500. Index funds in bear markets can be very painful, you need real stamina and balls to stand the wild swings if alot of money is involved.

While yes they do come back with a vengence too its more swing than i want in my life at this stage.

 

[ats5g]

Well, you're always going to get those that think that past performance is an indicator of future performance. Though, most of the studies I've seen conclude that there isn't much persistance in mutual fund performance.

One doesn't get to be an "associate vice president" by questioning the beliefs that make the brokerage firm the most money.

Virtually anyone who has been with a major national brokerage house more than 1 year in some sort of vice president, especially those that make the firm a whole lot of money touting those active funds that pay the most kickbacks make the firm the most money. You could ask this guy how much in commissions "business" he has to generate each year before he gets the can.

- Alec

 

[LOL!]

Add this study (touted on the MSN message boards) to your e-mail exchange:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=616981

It purports to shows that advisor-sold mutual funds have poorer returns than direct-sold funds. Thus advisors cost their clients money without providing any benefits for that cost.

 

[Alex]

Index funds are the way to go for most investors. The Bogleheads are right.

 

[jazz4cash]

I can tell you i have beat the indexes over the last 20 years with my actively managed funds and most important i did it with less overall risk than the s&p500. Index funds in bear markets can be very painful, you need real stamina and balls to stand the wild swings if alot of money is involved.

So........did you manage to beat the index by selling and riding out the bear markets? If so it seems that is comparing buy and hold to timing.

 

[Craig]

I had a similar conversation with a financial advisor one time. In that case, he explained that the returns on an S&P 500 index fund were somehow illusory, because the stocks making up the S&P 500 changed over time.


Yea, I know ... never made any sense to me either.

 

[JohnEyles]

He then stated that an investor in an SP 500 fund would have lost money since 2000 (he cited to the fact that the current SP500 index is lower than the March 2000 index level). I pointed out to him that the index does not account for reinvested dividends, and if he looks at VFINX (vanguard's 500 index fund), the 5 year performance is 6.8 percent, and that the average investor would have gotten respectable returns, far from losing money!

Not disputing your overall point, but ... if the SP500 index is lower (or equal to)
what it was in 2000, and overall return has averaged 6.8%, doesn't that imply
that the dividend yield was 6.8% or more ? What am I missing ?

 

[mathjak107]

The indexes dont include dividends, actually including the dividends the dow hit a new high 2 years ago.

 

[mathjak107]

I can tell you i have beat the indexes over the last 20 years with my actively managed funds and most important i did it with less overall risk than the s&p500. Index funds in bear markets can be very painful, you need real stamina and balls to stand the wild swings if alot of money is involved.

So........did you manage to beat the index by selling and riding out the bear markets? If so it seems that is comparing buy and hold to timing.

the active funds i had beat the heck out of the markets during the down turns because taken as a whole the model portfolio i follow had little technology and we had a 25% stake in bonds which gave us only a 14.5% drop on the entire model and plenty of cash to value average back into funds.

Its not only about the gains or losses of a particular fund, its about not losing to much in down turns and viewing the entire portfolio of investments as a whole.

 

[mathjak107]

I say it all the time, for retires its no longer about getting richer but about not growing poorer. the game at least for me has been to get most if not all of the returns of the various indexes but with less risk and swings.

unfourtunatly index funds by design always get loaded with the hot sectors since as the hot sectors become more over valued the more they dominate the index so when the crap hits the fan and those sectors take a hit index's can get hit pretty hard .

there are some nice etf's out there like a dvy but there isnt a long enough time frame yet to fully do a comparison . i would love to put together a model portfolio of lower cost index and etf's instead of my actively managed funds but so far i havent been able to track a model that beats my 13% long term average for over 20 years and still keep the swings down.

Dont forget im not talking a particular fund but a group of diversified funds covering many asset classes that work together. my active funds are swapped very infrequently but non the less like steering a ship the funds are changed periodically nudging the portfolio back on course as economic conditions, fund managers and fund investmens and goals change..

 

[Mr._johngalt]

I say it all the time, for retires its no longer about getting richer but about not growing poorer.

I say it all the time too, but I go about it in a very different way than almost
everyone else here.

JG

 

[Mr._johngalt]

I had a similar conversation with a financial advisor one time. In that case, he explained that the returns on an S&P 500 index fund were somehow illusory, because the stocks making up the S&P 500 changed over time.


Yea, I know ... never made any sense to me either.

This makes perfect sense to me. If the stocks change you're comparing
apples and oranges, from one period to another.

JG

 

[Dawg52]

i would love to put together a model portfolio of lower cost index and etf's instead of my actively managed funds but so far i havent been able to track a model that beats my 13% long term average for over 20 years and still keep the swings down.

Dont forget im not talking a particular fund but a group of diversified funds covering many asset classes that work together. my active funds are swapped very infrequently but non the less like steering a ship the funds are changed periodically nudging the portfolio back on course as economic conditions, fund managers and fund investmens and goals change..

Well I sincerely congratulate you! You have been able to do something the average investor has not been able to do. Below is the 2nd principle of investiing off the coffeehouse website.

2
There is no such thing as a free lunch.
(Capture the Entire Return of each asset class through low cost index funds)
Call it what you want, this is where Coffeehouse Investors and Wall Street part ways.

Wall Street, for obvious reasons, would prefer you try to capture more than the entire return of each asset class, in a never ending attempt to "beat the market." This results in more trades, transactions and profits for them - not you.

For Coffeehouse Investors, it is all a matter of common sense. Capturing the entire return of each asset class is a simple and sophisticated way to build a portfolio, and can be easily accomplished by investing in low cost, tax efficient, index funds .

Exhaustive studies have shown that it is difficult, if not impossible, to "beat the market" over the long haul. And yet that is exactly what Wall Street encourages you to do. The industry survives and thrives by trying to convince you to do what they themselves have proven is virtually impossible to do: consistently outperform a benchmark.
Remember, the decision is yours.

For serious investors, the question is not, "Can I beat the market?", but rather, "How can I limit if not totally eliminate 'underperformance' of the market?"



--------------------------------------------------------------------------------

 

[Mr._johngalt]

Well I sincerely congratulate you! You have been able to do something the average investor has not been able to do. Below is the 2nd principle of investiing off the coffeehouse website.

2
There is no such thing as a free lunch.
(Capture the Entire Return of each asset class through low cost index funds)
Call it what you want, this is where Coffeehouse Investors and Wall Street part ways.

Wall Street, for obvious reasons, would prefer you try to capture more than the entire return of each asset class, in a never ending attempt to "beat the market." This results in more trades, transactions and profits for them - not you.

For Coffeehouse Investors, it is all a matter of common sense. Capturing the entire return of each asset class is a simple and sophisticated way to build a portfolio, and can be easily accomplished by investing in low cost, tax efficient, index funds .

Exhaustive studies have shown that it is difficult, if not impossible, to "beat the market" over the long haul. And yet that is exactly what Wall Street encourages you to do. The industry survives and thrives by trying to convince you to do what they themselves have proven is virtually impossible to do: consistently outperform a benchmark.
Remember, the decision is yours.

For serious investors, the question is not, "Can I beat the market?", but rather, "How can I limit if not totally eliminate 'underperformance' of the market?"



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I generally ignore the posts about stock investing since I own none
and will not in the future, buit I must say that this post is just
excellent.

JG

 

[JustCurious]

Not disputing your overall point, but ... if the SP500 index is lower (or equal to)
what it was in 2000, and overall return has averaged 6.8%, doesn't that imply
that the dividend yield was 6.8% or more ? What am I missing ?

First, the 6.8 percent return figure is 5 years from Sept 01 to Sept 06, as compared to his reference point going back to the SP500 highpoint of March 2000. So, you first have to understand that the time reference periods are different, and the last 5 years were better in terms of performance than the last 6.5 years from March 2000.

Second, to answer your question, the dividend yield, on average, for the SP500 stocks is around 1.5 - 2 percent per year. So, for 5 years, that would add (approximately) 10 percent to your cumulative return, and about 1.5 to 2 percent to your average annual return. Therefore, if you just look at the SP500 index value five years ago and compare it today, that does NOT give you enough information to know the performance of the SP500 over the last 5 years...in fact it would give you a number that was lower than the true performance number. I was surprised that the "associate vice president" at a major brokerage either a) didn't know that, or b) was trying to mislead me.

By the way, if you want a handy reference index for the TOTAL stock market (not just the largest 500 stocks), that DOES account for reinvested dividends.... you can refer to the Dow Jones Wilshire 5000. (^DWC)

 

[JustCurious]

The indexes dont include dividends, actually including the dividends the dow hit a new high 2 years ago.

That's not true of all indexes. The Dow Jones Wilshire 5000 includes reinvested dividends, and it reflects the performance of the entire stock market. (^DWC)

 

[JustCurious]

This makes perfect sense to me. If the stocks change you're comparing
apples and oranges, from one period to another.

JG

Your response makes no sense. It's true that the composition of the SP500 index slowly changes over time because it generally tracks the larges 500 stocks, and of course companies continue to grow and contract, and the index reflects that. But the large cap actively managed mutual funds to which the index is compared also change over time as the manager buys and sells large cap stocks. The fact that the actively managed fund doesn't hold exactly the same stocks as the SP 500 doesn't mean that it is not a fair benchmark, and everyone in the financial industry understands that and most use the SP500 to measure the performance of large cap funds.

By your logic, you could never measure the performance of any actively managed fund because you would never have an index that maintained exactly the same stocks.

 

[Mr._johngalt]

Your response makes no sense. It's true that the composition of the SP500 index slowly changes over time because it generally tracks the larges 500 stocks, and of course companies continue to grow and contract, and the index reflects that. But the large cap actively managed mutual funds to which the index is compared also change over time as the manager buys and sells large cap stocks. The fact that the actively managed fund doesn't hold exactly the same stocks as the SP 500 doesn't mean that it is not a fair benchmark, and everyone in the financial industry understands that and most use the SP500 to measure the performance of large cap funds.

I see your point. Wasn't trying to be argumentative.

JG

By your logic, you could never measure the performance of any actively managed fund because you would never have an index that maintained exactly the same stocks.

 

[Mr._johngalt]

Oops, I see I screwed up the quote again. I understand why this stuff
is measured as it is. My only point is that if you have a "mix" at some point
compared to a "mix" of different stocks at another point, the argument could be made that you are comparing two (2) different things and drawing conclusions about "change" that may or may not have taken place.
Semantics? Maybe.

JG

 

[retire@40]

...Oops, I see I screwed up the quote again...

I can't understand how after over 7,000 posts here you still can't figure out how to 1) post with a quote and 2) go back and fix the original mistake without posting a second post on the same topic. It really isn't that difficult is it?

 

[FinanceDude]

Your response makes no sense. It's true that the composition of the SP500 index slowly changes over time because it generally tracks the larges 500 stocks, and of course companies continue to grow and contract, and the index reflects that.

Your analysis is well thought out, but your info on the S&P 500 Index fund is inaccuarate:

[url]http://www.beaconequityresearch.com/resource-ind_sp500.php [/url]

 

[brewer12345]

I can't understand how after over 7,000 posts here you still can't figure out how to 1) post with a quote and 2) go back and fix the original mistake without posting a second post on the same topic. It really isn't that difficult is it?

I think it stems from the same wellspring that gifts him with a shaky grasp of the real world and some issues with logic.

 

[FinanceDude]

I think it stems from the same wellspring that gifts him with a shaky grasp of the real world and some issues with logic.

Which is why we like him on here............a different perspective............

 

[mickeyd]

"Active investing is therefore a zero-sum game. The only way for one active investor to do better than average is for another active investor to do worse than average" Fortune's Formula (Page 170) by Willian Poundstone