Is your fund pro finally a prince?
The average mutual fund manager did edge out the market--again--last year. But the idea that people can really beat the indexes is still a fairy tale.
(MONEY Magazine) - In real life, the closest an investor can come to spinning straw into gold is to buy index funds and hold them for years. That's been an article of faith in my columns for more than a decade. Investing in the whole stock market gives you a blend of low costs and limited risk that, almost by definition, the average fund manager can't beat for long.
Yet 2005 marked the seventh straight year in which the average fund run by a human stock picker did beat Standard & Poor's 500-stock index. And for the decade ended Dec. 31, 2005, actively managed funds outperformed by the hair of their chinny-chin-chin, earning an annual average of 9.14% vs. 9.07% for the S&P 500.
Are the managers suddenly being watched over by a fairy godmother? After all, they start the contest at a huge disadvantage. The typical managed fund charges about 1.5% of your money each year in overhead. The cost of buying and selling stocks probably consumes another 1% of your annual return. An index fund, by contrast, incurs as little as 0.1% in overhead and almost no trading costs.
So stock pickers have to outperform indexers by at least two percentage points a year, before expenses, just to stay even.
That's no easy feat. But the recent numbers suggest that it has happened anyway -- and you're likely to read and hear more from the fund industry about this apparent triumph. In fact, a recent article in the Journal of Financial Planning suggests that indexing may not work anymore. "U.S. equity funds, as a whole," claims author Christopher Carosa, "offer better returns with either the same or less risk than investing in the market [with an S&P 500 index fund]."
Invoking Hans Christian Andersen's fairy tale of the emperor who had no clothes, Carosa concludes that indexing "may not yet be naked, but it certainly has fewer clothes than thought."
Not quite. The only fairy tale here is the idea that indexing is vanquished. Comparing the return of the average actively managed fund to that of the S&P 500 is a bit of trickery that can lead you down a dangerous path. Here's why.
Just What Is "the Market"?
Investing pundits and the financial press, MONEY included, often use the S&P 500 to represent the entire U.S. market. And in many ways it does.
The index accounts for about 70% of the stock market value of all publicly traded U.S. companies. Over the long run, there is very little difference between the returns of the whole market and the returns of the 500. But in the short run, large gaps can appear.
Last year the S&P 500 returned 4.9%. An index that better approximates the return on all stocks -- the Dow Jones Wilshire 5000 -- returned 6.4%. That's much closer to the "average" managed fund's 6.7%.
The remaining shortfall is easy to account for. There are 8,600 actively managed, diversified U.S. stock funds. Of those, fewer than 1,900 specialize in the mix of stocks that make up the S&P 500 -- big, muscular companies such as Pfizer, Wal-Mart and United Technologies.
All the other funds deal in small or mid-size stocks (or large stocks with special characteristics) whose returns can differ widely from the S&P 500's in the short term. For several years, small and mid-size stocks have been the market's sweet spot, soundly beating the 500.
So today's average managed fund has the wind at its back. But when the wind shifts, active funds will fall behind.
The fair question to ask of an active manager is whether he's beating an index made up of the kinds of stocks he specializes in. It's pretty easy for a race-car driver to lap an SUV. The true test of his skill is whether he's faster than the average race-car driver.
By that yardstick, active managers don't look nearly so swift. In six out of fund researcher Morningstar's nine classes of mutual funds (divvied up by the size and priciness of their stocks), indexers beat at least 50% of active managers last year.
For the 10 years ended in December, the indexers won in every category, beating an average of 74% of active funds. So the bottom line is that indexing still works, but not all indexes are created equal. In periods when smaller stocks zoom ahead, an SUV-style index like the S&P 500 will seem sluggish.
But there's a simple way around that: For your core holding, choose a stock market index fund tied to a broader benchmark like the Wilshire 5000. You can buy one from Fidelity, Vanguard or others. You will get a full fleet of large, mid-size and small stocks. No matter what does well, you'll own it.
If you want more small and mid-size stocks, which can grow faster but are riskier than big stocks, put 15% of your equity allocation in a small-cap index, 25% in a midcap index and 60% in an S&P 500 index, though I prefer the easy, one-fund strategy.
Finally, recall that other fable, the one about the tortoise and the hare. Indexing may plod in the short run, but it will prevail in the end. Nobel laureate William Sharpe outlined this logic in a classic 1991 article (www.stanford.edu/~wfsharpe). Since the whole can't be greater than the sum of its parts, the average fund can't beat the market average. Any other result, Sharpe argued, can be caused only by "improper measurement."
This brings us back to Christopher Carosa, whose article likened index funds to the emperor who had no clothes. Carosa runs a stock fund called Bullfinch Unrestricted. Over the past five years, Bullfinch beat the S&P 500 by a royal sum. It bested similar funds, according to fund researcher Lipper, by a much narrower margin. And Morningstar says Bullfinch lagged its benchmark badly.
The moral of our story: To turn the frog of active management into a prince, it pays not to look very closely.