Index funds beat active 90% of the time. Really?

My last article suggested six ways in which retired and retiring investors may be lulling themselves into a false sense of comfort. They do this by adhering to ideals that were originally postulated many years ago, and which today still have some merit.

But they’ve become clichés to a point where their foundation is no longer questioned when it needs to be. They are myths which need to be busted.

Busting a myth

Which myth are we busting this time around?

The one that’s made its way from the university research lab to the financial planning profession, then the mass-media, and ultimately became ingrained in the mind-set of many individual investors. Here's how it usually goes:"Professional (active) money managers don't beat the Standard & Poor’s 500 Index. Therefore, it’s a waste of time and money to pursue returns through professional managers."

The typical figure I hear is that 90% of managers don't beat the S&P 500 index, but I’m sure there are variations.

My firm recently completed a research study to see how valid this supposed ineptness of active managers is. We looked at the performance of the Vanguard 500 Index VFINX -0.29%  mutual fund (as a proxy for the S&P 500 IndexSPX -0.29% ) versus four mutual fund peer groups: All mutual funds (that is, traded in the U.S. — funds of all asset types were included), all stock (equity) funds, all large-cap stock funds and all large-cap blend funds. We determined how many of these funds were outperformed by the S&P 500 during each of six time periods:

  • 15 years ending Dec, 31, 2013

  • 10 years ending Dec, 31, 2013

  • The last two bull market cycles (see specific dates below — the second one goes through Dec, 31, 2013, though it obviously has continued through the first half of 2014.

  • The last two bear market cycles (see specific dates below)

For the bull and bear cycles, we tried to set their start/end points to the specific date at which the S&P 500 hit its ultimate top or bottom, based on daily closing prices. All fund and performance data was sourced from the Morningstar Direct software system.

No survivorship bias

Using the Morningstar Direct system allowed us to identify any funds that were operating during the time periods studied, but weren't open for the entire period. So, if a fund closed down or merged (which often happens due to sustained poor performance), it was included in the study, and was ranked below all funds that did exist for the entire period. Many studies of this type include only the funds that are alive today. This can artificially reduce the number of funds the index (or any other surviving fund) outperformed, since many losers drop out of the rankings altogether. By including ALL funds that existed during the period (even for just a small portion of it), our study is free of "survivorship bias."

Here is a summary of the results:

    1. Active and passive management each have potential benefits to investors

    2. The "90%" claim cannot be substantiated within the most relevant periods we studied over the past 15 years

    3. There is a noticeable tendency for the index to perform better than its active peers during friendlier market environments

    4. Before deciding on whether to employ active management, passive management or a combination, investors should first take a good look in the mirror and, at a minimum, determine these things:

  • What do they truly want out of their investment portfolio?

  • What is their personal performance benchmark? Very often, the investor shouldn’t be comparing themselves to the S&P 500 anyway. That would mean that they can withstand a 50% decline and take it in stride.

  • What is their likely reaction to the occasional stomach-turning drops that accompany long-term equity investing?

  • Regarding investment “time horizon,” how many and which time periods are most significant to them.

  • If the portfolio is being used for regular cash flow for lifestyle needs, what is the preference for how that cash flow is delivered?

Specifically, there were no time periods in which the S&P 500 outperformed 90% of mutual funds. The index was a middle-of-the-road performer in most of the 24 separate time period/peer group combinations we studied . During the two bull periods, the index outperformed 80% and 63% of its peers. However, during the down market cycles (bear), the index beat only 34% and 38% of its active management competitors. This is one of the most consistent conclusions we have seen in this and other studies — that active managers, in the aggregate, are effective in curbing some of the losses in the worst of times.

Our study showed that even when we narrowed the peer group from all funds, to all equity funds, then to large-cap funds and finally to large blend funds, the relative performance of the index fund didn't change dramatically.

When we averaged all 24 combinations of time frame and peer group, the index beat about 60% of funds. That is certainly competitive. But does it make the index the undisputed king of the mountain? No way.

What to do when everyone’s right

The whole point I am making is that the active-versus-passive debate should not be a debate at all. Both have merits, as you see in the data above.

The concern I have is that the popular vote has moved heavily toward the passive side over the past two decades, and this is what has created both the false sense of security and the "investor hubris" by indexing fans.

Regardless of whether you use passive investing, active investing or some combination, it is best to deal with facts, not a watered-down version of something that was true only at some point in the past.

Shortcuts in investing are convenient, but retirement investing isn’t about convenience. It’s about finding the straightest line between two points: the point you are at today and the one you want to get to.

Indexing your equity investments may get you there — or it may not.

Can’t we all just get along?

My hope is that our efforts will return the active-passive management issue to a healthy discussion and debate, which it used to be before it became a Yankees-Redsox-style ranting, mock-fest. More important, I hope the individual investor who questions the prevailing wisdom in this area, but cannot find the evidence to support their concerns, will have something to point to as they attempt to make the most informed decisions they can.

This article presented the conclusions of our study, “Active vs. Passive: Why They Both Win.” The full study includes a more detailed discussion of the very significant conclusions I think investors can take away from the study. It also points to other research studies (by Vanguard and American Association of Individual Investors, big indexing proponents), which reach similar conclusions to the ones we did here. The full study is available free by request at:

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