http://funds-newsletter.com
Copyright 2012 Tom Madell, PhD, Publisher
Nov. 2012. Updated Nov. 2, 2012

Contents:

-Should You Invest Only in Index Funds? Why Most Investors Continue to Say No
By Tom Madell

-Clear Risk of Falling Off the Fiscal Cliff: Here's Why
By Steve Shefler   (on separate page - to view, click here)

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Should You Invest Only in Index Funds? Why Most Investors Continue to Say No

According to the author of an article sent to me by one of my subscribers, the following is a "fact:"

If you buy actively managed mutual funds, then you will almost certainly under-perform an appropriate index by a MINIMUM of 2% per year, but you will probably under-perform by more.

The article goes on to state:

The only reason for buying an actively managed mutual fund is that there is an expectation that the fund is going to outperform the index with which it is associated."

Of course, it is true that when investing in funds, for every manager who beats the market, there logically must be money invested with a manager who underperforms it. Why? Because as a whole, all the money in the market by definition will perform identically as the market average. Thus, while some managers will do better than others, there must be an offsetting underperformance by the remaining ones. But this does not mean that the proportion of those beating the market vs. not is about equal, or 50-50. Why? Since all funds have some sort of expenses, including a cut to pay the fund itself, more funds will underperform their indexes, which do not reflect fees, than will outperform them.

When the markets are generally doing well, investors may not necessarily care that much or even particularly notice, that a fund is underperforming the index. Thus, if the S&P 500 Index has shown a double-digit return over a given period, and the investor's fund/funds have returned even a percent or two less, the investor likely still regards the outcome as highly satisfactory. But if the markets have done poorly, as was the generally the case over at least the last 5 years, underperforming an index can mean even worse returns, or even negative ones. Thus, in recent years, it is fair to say that investors have become a little less willing to take a chance on losing even more money than they would by just accepting average performance with an index fund or index-based ETF.

Given this information, one might expect to see the amount investors put into "passive" index funds greatly exceed the amount they have in actively managed funds. (A 2006 industry survey predicted that by 2016, 90% of all fund investments made by ordinary investors would be in such funds, while only 10% in managed funds.) So what is the current ratio of indexed vs. managed? According to the Investment Company Institute's latest data (2011), of $8.9 trillion invested in stock and bond funds, only $1.1 trillion was invested in index funds. Adding to that, the $1 trillion in index ETFs, it brings the percentage to only 21%. Clearly, the great majority of investors have still not bought into the premise that actively managed funds are to generally be avoided in favor of passively managed ones.

So, is it correct to assume that if you own one or more managed funds, "you will almost certainly under-perform an appropriate index by a MINIMUM of 2% per year," as stated above? There are so many clearly visible exceptions to this "fact" as to render it almost invalid. (Anyway, since when is a "fact" a statement of expectation about the future? Perhaps the author should restate his article's premise as "it is more probable that if you invest in a managed fund you will underperform its index than outperform it, perhaps by as much as several percentage points.")

While it is difficult to outperform the market, since the start of 2000, about 40% of managed funds have beaten their benchmark. (The above-mentioned article bases most of its conclusions on a study that mainly preceded 2000.) So the real question becomes why given a less than 50-50 chance of doing better with an index fund than a managed fund do investors still have the great majority of their investments in funds somewhat less likely to indeed do better? And given that they do, are they misguided, or, is there any rhyme or reason for having made such a choice and continuing to opt for it?

Many relatively older fund investors, such as myself, have come from a world where active management was pretty much the only game in town. After all, Vanguard's first index fund, the S&P 500 Index Fund (VFINX), started slowly out of the gate in 1976, and received only a little more than $10 million in assets during its initial several years, according to www.indexuniverse.com. The site reports that the fund was derogatively referred to as "Bogle's Folly" (John Bogle, who was responsible for starting Vanguard funds, was its founder.) Further, "the fund remained open only because it was the boss' project, not pulling in $10 billion until 1995."

Meanwhile, Fidelity Magellan (FMAGX), run by legendary investor Peter Lynch beginning in 1977, became the largest mutual fund of its day, growing to $56 billion over nearly the same period even as it went through several manager changes. In other words, to many fund investors, managed funds offered then, and perhaps still today, the possibility of eye-popping returns compared to mere "average" returns by the upstart index funds. Rightly or wrongly, such a view may remain as a motivating force for many of these investors.

While Magellan has long lost its luster, some investors still cling to the once behemoth fund to the tune of over $12 billion invested. But one such fund's underperformance, expecially after departure of the manager largely responsible for its success, does not mean that the cult of the potentially spectacular managed fund is dead. Recently, investors, although a relatively small number, have discovered perhaps a new way of seeking outsized performance vis-a-vis the indices. The Fairholme Fund (FAIRX), managed by Bruce Berkowitz, has beaten the S&P 500 10 out of the 12 full years since it began (while this year is not over, the lead it has over the Index is currently at an astonishing 22.4%, through 10-31). The average yearly outperformance, including this year, has amazingly topped 10%!

But before you get too excited, the fund lost 32.4% in 2011 compared to a gain of 2.1% for the Index although this is included in the above 12 year figure. This means that the fund can be highly volatile, making big bets on what it considers highly undervalued stocks - according to morningstar.com, it currently has almost 35% of the entire fund invested in a single stock and is highly undiversified, holding only about a dozen stocks. While this kind of "riches-to-rags" performance may scare the socks off of most fund investors, it's no wonder that some are willing to send their money to a man who is not afraid to shoot for the skies in an attempt to go along for the ride.

Other explanations have been attributed to investors for choosing managed funds that are not meant to be complimentary. For example, some have suggested that the average fund investor isn't very smart. For example, such investors might assume that any highly trained manager, or even the ordinary investor him/herself, should be able to use their thought processes to do better than a "non-thinking" index. Another view is that since many investors have been advised by commission-based advisors, the commissions, and thus the recommendations, tend to be much higher for managed funds than low-cost index funds. Others suggest that do-it-yourself investors often fall victim to the view that, due to self-flattering tendencies most people have about their own abilities, many investors tend to be highly confident that they can indeed pick those managers that will outperform.

My own personal view is that low cost funds should make up the majority of your investment portfolio, and many (but not all of these funds) will, by necessity be index funds and/or ETFs. However, there continue to be outstanding managed funds which have shown they have a good chance of beating the total returns of index funds. (Refer to my Dec. 11 Newsletter for examples). If for no other reason, diversification alone suggests including some well-chosen managed funds within the portfolio of an investor who has a relatively large portfolio (i.e. 100K or more of fund investments).

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