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    Do Index Funds Always Beat Managed Funds?

    Don Shaughnessy

    Posted on October 28, 2013 by

    Maybe not. It will behoove you to notice the parameters.

    It is a tenet of my life belief system that it is better to know nothing than it is to know something that I believe to be true but which is in fact untrue. When I know nothing I could be right by accident.

    For some time I have made the argument that index funds do not beat manged funds all the time, or even most of the time. Management fees, therefore, may be worth their price. Many disagree.

    There are several points to my belief:

    1. Index numbers do not mean the same thing as they used to mean. It is possible that losing to the index means nothing. At one time, say pre-1995, the index numbers represented the value of the businesses in the index and changes measured how the underlying fundamentals of the businesses changed and how the expectations of the buyers of the securities saw things into the future. That is not the case any longer. High velocity trading is different. At one time much of the trading in large corporations was of the buy and hold variety. As late as 2006 high frequency trading was about 9% of the trading, but by 2010 it was over 60%. The index value to volume correlation was once strongly positive, it is now random. The “meaning” of a trade that is fully cycled within 10 milliseconds is different than a trade that cycles over 10 years. No one invests for the dividend return in a millisecond world. Dividends are an important part of the definition of a business. Therefore a large percentage of the trades do not relate to the business aspects of the index.
    2. The existence of index funds alters the value of the index. As index funds grow in popularity there is greater demand and thus price increase for the securities that make up the index. That demand has exactly zero to do with the business expectations of the companies in the index and exactly zero to do with the buyer’s expectations for their future success, but it does depress the comparative results for managed funds.
    3. There is empirical evidence to dispute the idea that index funds beat managed funds. Capital Group, the proprietor of the “American Funds” family is pretty obscure but large. By December 2007 they ran 7 of the 10 largest funds in the United States but were nearly invisible. They issued three press releases after 1925.They recently compiled information based on rolling monthly periods from December 1933 to December 2012, a period of 80 years. (I am aware of the value of end point biases and checked December 1933. It was low but not as low as 1932. It may affect some of their results, but the index itself covers the same periods.)
    • They compared their funds to indices over several rolling month-end hold periods, 1-yr. 3-yr, 5-yr, 10-yr, 20-yr, and 30-yr. There are over 30,000 results in the study. For instance there are 600 month-end results for 30 year holds for each of their funds. They found that the funds beat indices as follows:
      • 1-year period – 57%
      • 5-year period – 67%
      • 20-year period – 83%

    The Capital Group information conflicts with a comparison provided by S&P in June 2013. An example of its result is that over 5-year periods, the index beat managed equity funds 72.14% of the time. Quite a difference. How come?

    The average fund as used by S&P includes both the best and the worst managers. You can deal with whoever you want but you cannot deal with “average manager.” Averages then are not meaningful to you if you can choose to deal with particular managers. Index funds beat the average managed fund is not equivalent to Index funds beat all managed funds.

    It pays to notice how particular managers do what they do. Some can approach index return values after fees while holding 20% or more of the assets of the fund in cash. While not producing the highest yields year over year, they tend to be more stable and more tax efficient.

    Fund management fees include custodial, trading and tax reporting costs. More importantly they used to include amounts paid to local advisers. It is probable that advisers add nothing to fund returns but despite that, people who use advisers tend to end up with more money.

    You can spend money, you cannot spend percentage gains. A large portfolio is only partly the result of investment returns. Capital value arises from disciplined capital investment, tax sensitivity, and from choosing the better managers. Advisers add great value to those parameters.

    A competent adviser will spend time organizing a plan and a portfolio, but even more time managing you. That is where the real money turns out to be. You should not expect to get thr service for free.

    As always, pay attention. The world, fundamentally, is just organized common sense.

    Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

    The MONEY® Network