2003 Standard and Poor’s Analysis Confirms Benefits of Index Investing¹

If you’ve met with us or read the relevant materials on our website, you’re probably familiar with our argument that you should select index funds for your portfolio:

1. Index funds are less expensive investment vehicles than managed funds. Even though the cost advantage appears small, over most investors’ time horizons the cumulative impact is very large.
   
   
2. Index funds regularly outperform most managed funds. This effect is stronger the longer your investing horizon.
   
   
3. It is impossible to determine in advance which managed funds will outperform the relevant index.
   
   

Standard and Poor’s reports regularly on managed mutual fund performance relative to the relevant indices. A recent report², for the period ending in the first quarter of 2003, is the source of the data in this article. It focuses on point 2, managed fund underperformance³. Their report also touches on other issues of interest to long-term investors like you. The data suggest that:

• In the short term, managed funds can win. Over the last quarter, fewer than 50% of managed funds were outperformed by the relevant index.
• In the longer run, managed funds tend to lose. Over the last year, three years and five years, the results are reversed, with more than 60% of managed funds failing to outperform the relevant index. The average investor’s odds of purchasing a fund that would outperform the comparable index were less than 2 in 5. As the chart above suggests, the longer the time period, the larger the percentage of funds outperformed by the index.
• Investors in managed funds obtain worse results than the index over the longer term. Over the last quarter, the average investor in a managed mid-cap or small cap fund enjoyed results better than the index. Over the five year period, however, the average managed fund performance disadvantage was about 1% per year.

Now, you can’t buy the index for nothing, but you can buy an index fund for .2% - .3%, leaving you with a .7%-.8% advantage. This finding for all US managed funds held for large and small cap funds, while for mid-cap funds the disadvantage was even greater. Unfortunately, the whole US market was down over the period, but the average investor would have lost 3.5% - 4% less with an index fund than with the average managed fund. By the way, some industry observers believe that active managers outperform the index in a bear market. These results would seem to conflict with that view.

• Managed US equity funds can close or merge at a disconcerting rate. In most domestic equity asset classes, between 10% and 20% of the managed funds liquidated or merged over the five years S&P studied. More than 1 in 10 of the managed US equity funds operating in the second quarter of 1998 had closed or merged by the end of first quarter 2003.

  

• Managed funds demonstrate poor style consistency. Over the last five years, in only 3 of 9 asset classes did 50% or more of managed funds stuck to their style for the whole period. In the class demonstrating most consistency, large cap value, only 60% of funds performed like the large cap value asset class throughout the whole period. In other words, not only did managed funds tend to underperform the index, but they also tended to drift away.

  

The bottom line?

Relative to buying an index fund, buying a managed US equity fund is a gamble:

• It is unlikely to outperform the relevant index, especially if you intend to hold it for a reasonable period of time (3-5 years). The performance disadvantage can be substantial.
• The fund is likely to change over the time that you hold it, either by going out of business or by changing the nature of its holdings.

In assessing the reliability of these results, you should bear in mind that S&P has an interest in the sale of index funds based on its indices. On the other hand, S&P does its work very carefully⁴. Its bond-rating business depends very heavily on its hard-earned reputation for objectivity. Finally, by publishing its results and methodology on a regular basis, S&P allows anyone who might disagree to respond publicly. So far, no one has.

Standard and Poor’s methodology

• S&P corrects for “survivorship bias.” Managed funds that perform poorly tend to be liquidated or merged. Investors in these funds experience poor returns that are reflected in managed fund return estimates only if this correction is made.
• S&P compares managed fund returns to a relevant index. For example, the S&P report compares managed mid-cap funds to the S&P MidCap 400 rather than to the S&P 500. Midcap stocks have more risk and higher expected returns than large cap stocks – S&P is making a fair comparison, while studies that aren’t as careful can be biased. [Recent academic analyses recognize that many funds hold securities from multiple asset classes, and compare each fund’s performance to a combination of relevant indices. This makes the comparison more accurate, but requires a lot of work.]
• S&P provides asset-weighted returns for the managed funds, providing perspective on the experience of the average investor. Funds with more assets typically have more investors, and are more indicative of the experience of the average investor.
• S&P corrects for the tendency of many funds to “drift” from their announced style to a style that seems to be producing better returns at the moment – for example, a large cap value fund that might have bought growth stocks during the boom of the late 90’s would be classified as a growth fund by S&P for that period of time.

¹This article uses data and information published by Standard & Poor’s. However, the views, interpretations and conclusions expressed are Sensible Financial’s. The author bears sole responsibility for any errors.

²We wrote this article in 2003. Standard & Poor’s publishes this information every quarter.

³"Standard & Poor's Indices Versus Active Funds Scorecard, First Quarter 2003." View it directly , or access it from inside the ‘Index Highlights’ box.

⁴In particular, it makes several adjustments to ensure accurate comparisons, correcting for “survivorship bias,” using precise benchmarks, reporting on the experience of the average investor (not the average fund), and correcting for “style drift” (the tendency of active managers to chase performance outside of their chosen areas – to seek greener pastures). For more detail, see the section on S&P analysis methods immediately following, or read their report.