Much has been written about the trend toward bypassing managed funds and investing instead in index funds and/or ETFs. And yet, to
my way of thinking, the prevailing discussion fails to focus on the main reasons why index funds, especially S&P 500-type funds, have
been doing so much better than the majority of managed funds, especially recently. In this Newsletter, I will try to clarify this shortcoming.
Frankly, I am tired of reading statements suggesting that those who assemble portfolios of stocks and typically earn an
big salary for so doing,
namely fund managers, are generally very poor at what they do since they, more often than not, trail the returns of the S&P 500 index.
In my main article to the right, I discuss some of the primary, but often, unrecognized reasons why many fund managers these days are
underperforming the S&P index. What follows below are some additional thoughts, which not everybody may agree with, on the subject.
It might be useful to think about who invests in stocks and to consider how they choose to do it.
Some invest in stocks per se while others invest in
the stock market through mutual funds and ETFs. It is generally perceived to be the case that more hands-on, and to that extent, more knowledgeable
investors, choose direct stock ownership, while those less so choose funds and ETFs. This is not to say that all fund/ETF investors
are necessarily less knowledgeable, but rather that, on average, a great percentage of fund investors are those who do not have the time
and/or interest, or the relatively
greater willingness to undertake the added risk involved in individual stock investing.
on page 5)
Crucial Facts When Evaluating Unmanaged Vs. Managed Funds
By Tom Madell
Investors these days are more and more likely to be bombarded by the notion that mutual fund managers must be poor at what they do because
the vast majority of these pros fail to surpass the performance of the S&P 500 index, the most commonly used benchmark in
judging portfolio proficiency.
The swelling tide of opinion against using fund managers, as opposed to investing in a non-managed fund or ETF
that merely mimics the index itself, is often extended
even further to argue that all stock investments are inherently unpredictable. If so, fund investors are always much
better off in the lowest cost variants, namely index-tracking funds and unmanaged ETFs, since even if a manager is successful
in equaling the performance of the
index, higher management and trading fees will cause him/her to wind up underperforming the index.
The movement away from managed funds, and toward passive ones, has been gaining more and more adherents. Of course, the longer
non-managed funds outperform as compared to managed ones, the more these beliefs will be reinforced. And for quite a while now, and
most notably so far this year, the non-managed funds are beating
the pants off managed ones.
As of Nov. 26, while the S&P 500 index was up 14.3% including dividends, a quick glance at the year-to-date performance
of most managed stock funds shows the great majority are up considerably less. In fact, over the last 1, 3, 5, and 10 year periods,
the index has beaten
the annualized total return of the average US diversified stock fund, as shown below.
sified US Fund
Data as of Nov. 1
(continued on page 2
(Crucial Facts When Evaluating Unmanaged Vs. Managed Funds,
continued from page 1)
So why should anyone want to continue to have any
investments in most other funds,
except perhaps for a total stock market index fund such as Vanguard Total Stock Market Index (VTSMX) or Vanguard Total Stock Market ETF
(VTI) which go beyond
including just the biggest capitalization stocks?
Are fund managers really as unable to add value when picking stocks and deciding on these stocks' allocations within their funds
as this data seem to suggest?
And does this mean that an unmanaged
S&P 500 index fund is almost always a smarter long-term investment than most any managed Large Cap fund offered
by the myriad of fund companies out there?
Many investors apparently
seem to believe so: Aside from investing a whopping $355 billion in VTSMX (whose 25 largest holdings are virtually identical with that
of the S&P 500), the next 3 largest funds (which include one ETF), are all
S&P 500 variants with a combined total of about $540 billion. By contrast, of all managed funds, the biggest,
American Funds Growth Fund of America (AGTHX), checks in at "only" $140 billion.
S&P 500-matching funds have certainly become the giants in the room among fund investors.
To answer the above questions, we need to look at a variety of information
which will help shed light on the current widely observed performance
gap between the S&P index and the majority of managed investments.
What we will find is that many investors overlook certain crucial differences between their S&P index-derived
funds and funds competing in the same space as managed ones, other than some of the more obvious, well-known ones.
By closely examining these differences as well as the rationales behind them,
I believe I can show that many of the arguments leveled against managed funds turn out to be greatly diminished.
Fact 1. Most Large Cap managed funds are not solely invested in US stocks, and therefore, should not perform similarly to S&P-type funds/ETFs.
Of course, the S&P 500 index is invested exclusively in US stocks. But this is not so for the great majority of managed Large Cap stock funds with
which a S&P 500 index fund is competing.
So why would a fund manager choose to allocate assets elsewhere?
Many widely cited long-term research comparisons have shown that a portfolio that combines U.S. equities with international
stocks often performs better than a US-only portfolio with lower overall volatility.
Since lower volatility
is a plus for most investors, it is easy to see why fund managers often choose to include foreign stocks. In fact, according
to the U.S. Securities and Exchange Commission (SEC), one of whose functions is to protect as well as educate investors:
By including exposure to both domestic and foreign stocks in your portfolio, you'll reduce the risk that you'll lose money
and your portfolio's overall investment returns will have a smoother ride. (Italics added; source: http://www.sec.gov/investor/pubs/ininvest.htm ).
These benefits are generally a result of diversification and the fact that
international stocks sometimes perform better than US stocks.
Therefore, while unmanaged US S&P 500 index-based funds must adhere extremely closely to their index,
most managed funds, it would seem, may assume that it is
actually in the their investors' best interests (along with the fund company's too, since they obviously prefer to retain investors)
to fashion a somewhat more diversified portfolio than just US stocks alone.
Another reason most Large Cap funds (actually, almost all managed funds) aren't totally invested
in US stocks:
Usually, most maintain at least a small cash position. Without such cash on hand, whenever a selloff does hit and a
potentially above average number of investors choose to bail out, a manager might be forced
to sell certain holdings in order to meet the redemptions. Such
holdings might be viewed as having long-term potential to do well, but might require being sold at fire-sale prices as a result of the selloff.
Clearly, there may be the need for some sort of a safety mechanism to avoid this, just as an individual investor who must liquidate some
investments due to an emergency requiring immediate cash wouldn't want to be forced to sell at a seemingly inappropriate time from his stock portfolio. Some cash
on hand can provide that mechanism, but at the expense of potentially losing out on a more profitable investment for the amounts held back.
Unfortunately though, over the last 5 years, both foreign stocks, and of course cash, have severely underperformed US stocks.
speaking, the more a fund allocated to these two areas, the greater the odds that it would have underperformed a S&P index fund/ETF that might
have next to nothing in these two areas.
The following data show each area's performance, first so far in 2014, and then for the last five years (annualized; all data below
as of Nov. 26):
Cash (Vanguard Prime Money Market) 0.01, (0.04)
Non-US Stocks (benchmark: iShares MSCI ACWI ex US ETF) 0.17, (4.72)
S&P 500 14.26, (15.70)
While allocating a considerable portion of a
portfolio outside of US stocks and to cash would not guarantee underperformance in recent years, certainly in terms of probabilities,
the higher the combined weighting to these two non-US-stock categories, the more likely
a managed portfolio would be dragged down by the lower average performances of foreign stocks and cash.
Let's look at a real example. Consider the recent performance of the Dodge & Cox Stock Fund (DODGX), an outstanding managed fund with
who, over the last 15 years, have outperformed the S&P 500 by an average 4.63% per year.
Yet, for 2014, the fund is trailing the index by about 3.3%. Does
this suggest that perhaps the managers are losing their touch? When we factor in the above considerations, that would not appear
to be the case.
Roughly only 1% of the portfolio
is being held in cash, so that could hardly be impairing performance much. But what about the 13% or so that is
currently held in foreign stocks?
While its 10 largest
US holdings as of late November, accounting for about 1/3 of the portfolio
are returning 20.2% year-to-date, better than the S&P 500's 14.3% return, it is unlikely that its foreign
holdings are doing anywhere near as well
given the average severe underperformance of international stocks shown above.
The likely explanation, then, for the subpar recent performance is the fund's decision to invest a moderate amount of its
If we compare
this 13% to that of the largest Large Cap funds by assets, we see that this percent is larger than its competitors. Had the fund chosen not to
invest in international stocks, it more than likely would have been able to beat the index.
So, taken together, should you therefore conclude that managed funds that attempt to diversify by adding international stocks and
that maintain a cash position are to be avoided?
While the concept of diversification
is sound, many investors already have one or more separate funds in their portfolio that meet the need for international exposure.
In this case, perhaps a fund such as DODGX may be best for
investors who only have that one fund, or perhaps several, but with little or no international exposure.
That said, one must still consider
DODGX's outstanding long-term track record. In fact, much of that track record was generated when international stocks were
outperforming the S&P,
unlike the last 5 years. For example, in the prior half-decade between Oct. 2004 and Oct. 2009, international stocks
did outperform the S&P 500
index. Furthermore, even cash in a money market fund outperformed the index as it suffered during the 2007-2009 bear market.
According to the Wall Street Journal, the average International
stock fund returned 5.8% annualized during that period vs. the S&P's 1.0%
During this period, then, this would of course have most likely helped a more diversified fund that included these assets.
And, in fact, during this
period, the average US stock fund did outperform the average S&P 500 fund.
This data shows that investors should not assume that a S&P-type index fund
will always do better than a managed fund just because this has been true over the last 5 years.
Nor should one assume that fund managers are somehow always likely to make
market underperforming choices when assembling a
portfolio as compared to an unmanaged index.
Fact 2. S&P 500-type funds/ETFs are very heavily weighted to the largest stocks and will only outperform when these largest stocks are
outperforming most other stocks;
however, historically, smaller cap stocks have outperformed during many extended periods.
Although the S&P 500 index is made up of 500 stocks, it is actually heavily influenced by a much fewer number.
The reason is that the construction of the index gives the highest allocations to stocks with largest market capitalizations, such as
Apple, Exxon Mobil, Microsoft, Johnson & Johnson, and General Electric. Right now, the performance of these 5 stocks alone will account
for about 11% of how the index does on any given day. In fact, the largest 25 stocks in the index account for nearly one third of the daily
performance. This overweighting of the largest companies has important implications for investors and for their portfolios if they
hold quite a bit of their assets in a S&P 500-type ETF or fund.
Currently, the largest stocks in the
overall market are doing the best. The average 2014 return on the above 5 stocks as of late Nov. was 19.2%;
the return on the largest 25 stocks was approximately 15.9%.
It is easy to see then that the remaining 475 stocks are somewhat underperforming the largest stocks since the entire portfolio is returning 14.3%.
With this the case, it is difficult for a well-diversified mutual fund to outperform the index since such a
fund will generally will want to pick from
a variety of stocks without closely duplicating the index. However, whenever the largest
stocks are not at the top of the performance charts, a more diversified fund can do better.
So a conundrum for a fund manager develops: Unless he/she also owns primarily these huge, well-performing stocks,
it will be difficult for him/her to beat the index. As with including international stocks under Fact 1 above,
many managers favor a more diversified allocation that does not always include a heavy weighting toward the largest of the Large Caps
as does the "top-heavy" index.
As a likely result of recent underperformance, some fund managers become "closet indexers" to attempt to do as well as the index;
they pick the same stocks
that are resulting in big gains for the index. But of course, the managed
funds have higher fees, pulling them below the index even if they essentially copy it. And seeing the better performance of the index,
individual investors themselves move a greater amount to these S&P 500-like funds than they might have otherwise.
The more fund investors move toward index investing, the more the index fund must buy those biggest stocks. This creates a virtuous cycle
for these stocks since index fund buying pushes the market caps and prices of the biggest stocks even higher. Even purchases
by closet indexers help to push
up the prices of these biggest stocks which are then reflected in even higher capitalizations and allocations within the index.
A recent article on bloomberg.com pointed out that fewer individual
equities are beating the index than any time since 1999. The average of about
1675 stocks included in
the Value Line Arithmetic index was recently up 6.9% this year while the S&P 500 was up 12.1%, both excluding dividends.
(Using the actual mean, as opposed to the S&P index's method of
giving much bigger weights depending on the total market value of each stock, more closely shows
the performance of stocks if you held the stocks in equal amounts.
The daily price change of the Value Line Arithmetic Index is calculated by adding the daily percent change of all the stocks, and then
dividing by the total number of stocks.)
Will this momentum of the largest stocks
always cause the S&P index to outperform as it has done so dramatically thus far this year and to a lesser extent over the
last 5 years? Only if these largest of stocks continue to outperform. Once these stocks start lagging, the index will suffer
disproportionately and the index will underperform a more balanced portfolio of stocks. In fact, if one goes
back 5 and 10 years ago, this is exactly what happened.
The average stock fund outperformed the index between Oct. 2004 and Oct. 2009 by about 1% and by about 3% between Oct. 1999 and Oct. 2004,
according to data published in the Wall Street Journal. And,
in fact, over the full 10 years, the average S&P 500 fund returned slightly less than the average US diversified stock fund.
Fact 3. Index funds do not provide a risk control mechanism, and so index investors who want this will need to provide it for themselves.
This statement is true because in index funds only you are really at the helm; you determine how much risk to bear
through your decisions to either be in the fund or not, and if you are in, how much to keep in the fund.
The fund operates on auto-pilot, merely by mirroring the changes that occur in the index, out of any one person's control.
When you invest in a managed fund, while you still have ultimate control over your allocation to the fund, the fund manager typically
has control over how much of your investment should remain fully invested. If he/she determines that market risk appears too high, the manager
can reduce overall exposure to stocks.
Further, the manager can control the risk level by avoiding sectors and/or specific stocks that appear too pricey or are
currently in free fall and by focusing on those sectors/stocks that do appear to have more favorable forward-looking characteristics.
While there is no guarantee that the manager's choices will be correct, an experienced and skilled manager can add value by controlling
such risks in a way that an index fund cannot.
It follows that unless you are ready to act on your own behalf to control these risks, perhaps you may want to think twice about
investing most, or all, of your money in index funds.
Many managed funds will only buy stocks they consider undervalued, or at least fairly valued. Since many of the largest stocks
in the S&P 500 currently do not meet this criterion, managers may be underweight in the overvalued areas.
In these recent good years for stocks, the S&P 500 has tended to become more and more
loaded with prior winners without regard to valuation. Of course, evaluation of which stocks are at fair value or below, and which are not,
is not something that index funds were designed to do.
However, this is not typically the case for managed funds.
A good manager tries to avoid particularly overvalued stocks and concentrate on finding undervalued ones, or, at least, less
overvalued ones. While this strategy may not pay off in the short run as the overvalued areas keep running up further, it makes sense
to believe that eventually these areas will be stripped of their excessive gains and the undervalued areas will prevail. Unfortunately, though,
with so many stocks currently overvalued, it may be difficult for even skilled managers to find alternatives right now.
(Fire Fund Managers? Not So Fast!,
continued from page 1)
Generally speaking, individual stocks
are typically viewed as providing greater reward possibilities than funds. Investors can research important company and economic
fundamentals and choose a relatively small number of companies they have the most confidence can do well, presumably performing better than
a large basket of assorted companies, some of which will undoubtedly do poorly, cancelling out many of the good performers. At least, that appears
to be how the thinking goes.
If we accept the above implied assumption that even professional, highly salaried fund managers with degrees in business, finance, economics, etc.
cannot outperform the S&P, one can imagine what this should imply about typically less well-trained
individual stock investors managing their own investments, i.e. the ordinary stock-buying public.
What it would seem to
suggest is millions of owners of individual stocks who are doomed to likely do even worse than presumably skilled managers in their
investing vs. just investing in the S&P index.
However, using one common line of reasoning, the average return of all individual stock investors
should equal that of the index,
minus whatever brokerage charges they pay to buy stocks, at least in the large cap arena that S&P 500 stocks lie.
So, on this basis, it would appear that owners of individual stocks,
all things being equal, should have an even chance of coming out as well as all others participating in the market,
assuming the fees of ownership were
about the same. Of course, another possibility exists: Perhaps it might be that while the average performance might be the same, some
individual stock owners might do extremely badly while others would come out way ahead, balancing each other out. If so, having a
professional fund manager might provide one with a type of insurance against disastrous results.
If I am correct in what I've said thus far, the main performance disadvantage then of owning a managed fund
might be just the higher fees one has to pay
the fund as opposed to just owning S&P index funds or owning individual stocks, rather than assuming typically
poor investment choices by fund managers.
Incidentally, I find the notion that individual stock owners and career managers are somehow worse investors than the generally less
knowledgeable public who invest in S&P-type index funds patently
ridiculous. Yet one finds articles stating "Fire fund managers" all the time.
You might, of course, argue that the main problem is that owners of stocks and fund managers trade too much
or have more performance-harming biases as compared to the less knowledgeable investor. These speculative inferences,
I suggest, would need to be substantiated through actual research;
while indexes themselves may do quite well,
many fund investors themselves are well known to also exhibit these same tendencies in their buying and selling of funds,
along with the performance chasing
that nearly always lowers actual "investor returns" as opposed to the fund
reported returns. (According to Morningstar, the 10- and 15-year annualized
investor returns for the Vanguard 500 Index Fund (VFINX) are currently 6.34% and 1.98%, or approximately 2% less than the reported returns.)
If one agrees that the main underperformance of funds vs. the indices is attributable to extra fees, this still assumes
that managers in general are not particularly good at picking stocks since otherwise they should have a good
shot at coming out ahead in spite of the fee disadvantage. But if we look at some additional information
as presented in my main article beginning on page 1,
we will see that even this conclusion may not be accurate. There are a variety of reasons why managed funds have tended to
trail unmanaged funds, especially recently, other than assuming that professional managers
are no better in picking stocks than throwing darts at a list of stocks.
If not currently a subscriber and wish to sign up to receive notification of new Newsletter postings as well as infrequent,
but crucial, investment Alerts,
If you find this month's Newsletter helpful, consider pasting this link to it in an email to a friend: