Copyright 2016 Tom Madell, PhD, Publisher
Nov./Dec. 2016. Published Oct. 28, 2016.

Is Skill Still Relevant in the Era of the Indexes?

By Tom Madell

Anyone failing to notice that index funds, along with index-based ETFs are, day-by-day, becoming the preferred investments for investors likely hasn't been paying much attention. So it's more important than ever to consider the question of whether portfolios still managed based on presumably skillful interventions can realistically ever hope to consistently beat portfolios run on autopilot, that is, passively managed and made up of index funds.

More and more, this question seems to be spiraling toward a consensus conclusion: Managers and active investors, it is now said, are almost deluding themselves if they continue to think that they can ever hope to come out ahead long term over the currently most popular index funds that charge so little and, additionally, help to take all the pain and guesswork out of deciding where to invest.

Therefore, as the debate becomes one-sided favoring index funds over managed ones as well as ETFs over ordinary mutual funds, many might think I am trying to defend an almost an indefensible position these days, namely, that actively managing your own portfolio, or using "old-fashioned," managed funds, or both, can result in just as good or even better outcomes than very little activity or just using the most popular broad "total market" index funds or ETFs.

Is there a place for "skill" in investing, or, has that now been shown to be a "mirage," perhaps perpetuated by those who want to continue to make a profit by "managing" our money in spite of evidence suggesting that you will typically do better without them, just by investing in the indexes?

While I am fully aware that just holding broad-based index funds or their nearly identical ETF versions have shown some superiority, especially recently, it turns out that this is far from the whole story.

Essentially, one's position regarding the debate boils down to how one comes down on the following two questions:

  • a) Is it possible for someone to determine in advance, with any degree of accuracy and consistency, where and in what relative amounts, to position investments to come out ahead of a fixed allocation, index-only, portfolio? Or,
  • b) are such efforts nearly impossible to get correct enough of the time to merit even trying?

If you answer b) yes, you will lean toward indexing and indexed ETFs and your own passive management of your portfolio; if, however, you answer a) yes, you likely will be open to using a variety of types of investments in your portfolio, and possibly, in choosing some degree of active involvement on your part in portfolio decision making.

Down through the years, I myself have been open to using all types of stock and bond investments with the result that, even though over the last two or three years, my overall stock fund choices have somewhat trailed broad market indexes, the opposite is true over a full five years. And my bond fund choices have recently beaten the appropriate indexes regardless of how long held. (All results discussed in this article, as in all my articles, are after all fund expenses are factored in.)

Sure, if you want simplicity and to be relieved of making sometimes stressful decisions above all else, even above potential returns, broad, entire-market-encompassing index funds (i.e. "total stock market" funds) or similarly matched ETFs, are the way to go. But if you have any confidence at all that investment results are more predictable than, say, into which slot a rotating roulette ball will land around a spinning wheel, then you may want to consider spreading out your investments, some in such broad index funds, some more narrowly defined index funds (i.e. value or small cap funds), and some in managed ones, while yourself not opting for a completely "hands-off," passive approach year after year.

Broad index funds provide assurance you won't miss out on the returns passive investors have been receiving, which have been outstanding recently. The other types just mentioned give you the opportunity to make use of the acquired knowledge that either skilled managers have presumably accumulated, or you yourself can come to possess, not only in selecting which more specialized stock or bond funds to include, and in what amounts, but in deciding when to initiate, add to, or lighten up on those investments.

While no amount of mere words is likely to resolve the active vs. passive dilemma, investors should at least be aware that not all evidence always point to the superiority of passive management. If a hands-off approach was so clearly the slam-dunk winner that its advocates claim, none of the data in the remainder of this Newsletter could have likely turned out the way they did.


It Was a Very, Very Good Five Years: Part I

Some of you may have heard an old Frank Sinatra song called "It Was a Very Good Year." And when considering the performance of many investors' portfolios, that too might be a very apt title to describe the past 12 months. Of course, one would have to exclude any money parked in nearly risk-free positions in cash, money market accounts, or CDs.

But this title could be modified slightly to describe returns over the past five years as "It Was a Very, Very Good Five Years." The reason becomes apparent as you examine either the performances of the broad benchmark indexes, my Model Portfolios, and, even to a lesser extent, the average U.S. stock or bond fund.

I take for granted that the just mentioned indexes, that is the three Vanguard funds I use to compare my diversified Model Stock Portfolio against, should typically be excellent choices, and generally speaking, among the hardest benchmarks for any similarly diversified investor portfolio to come out ahead of. But, nevertheless, past Model Stock Portfolio results have shown why I persist creating these Portfolios, with a high percentage of previously recommended Portfolios exceeding these top-notch benchmarks.

Although very good absolute returns such as 11.6% for our Model Stock Portfolio over the last 12 months are nothing to sneeze at, I would obviously be happier if my recommended Portfolio could have bested the 12.9% return achieved by merely investing in the three Vanguard funds in the constant percentages I deem necessary to achieve proper diversification. (Note: One is a total U.S. market index fund, while the other two index the rest of world; see the Note below for details.)

But a single year's outcome is not a long enough period to judge any portfolio's effectiveness. One often has to wait two or three years to see whether any given fund in my Portfolio, often chosen on the basis of being potentially undervalued, is going to show the outperformance expected. Unfortunately, though, it can sometimes take as many as five years.

This can certainly test one's patience as well as resolve. But the results shown in past years, as well those given below, reaffirm my confidence that even with the generally highly satisfactory returns available from the broad indexes (although not always so), it is still frequently possible to do even better, as my Model Portfolios often have, when measured over the long term.

And while my bond fund recommendations have come out ahead of their commonly used benchmark over the latest 1, 3, and 5 years, this obviously won't always be the case. Looking for outperformance to occur after at least 2 or 3 years is once again more likely.

To be honest, my investment recommendations don't always do as well as I'd like, nor as quickly as I'd wish. This typically seems to happen when judging results over the short term.

It is certainly one frustrating aspect of investing that no matter how much research you do, nor no matter how knowledgeable you might think you are, you may not succeed as much as you expect, nor even do as well as simply buying and holding a few well-known index funds. Does this mean that index funds are inherently superior? Certainly, they start out with usually a small advantage in terms of being less expensive, which accounts for some of their performance advantage. And active manipulation of a portfolio may subject the portfolio to overreacting to what turn out to be insignificant and passing events.

But skillful investors and fund managers can overcome these pitfalls by focusing on only the most glaring situations to prompt action such as gross ‌instances of over- and undervaluation, while ignoring almost all other factors. Of course, unmanaged index funds cannot "react" at all to such occurrences, which is their biggest disadvantage and why skillfully managed portfolios can come out ahead.

With that in mind, let's review specifically how my recommendations from Model Portfolios presented 1, 3, and 5 years ago did.

Note: Our benchmark portfolio against which we measure our Model Stock Portfolios remains

Vanguard Total Stock Market Index Inv (VTSMX)      65%
Vanguard Developed Markets Idx Admiral (VTMGX) 30%
Vanguard Emerging Markets Idx Inv (VEIEX)               5%

One Year Ago (Oct. 2015)

As already mentioned, my Model Stock Portfolio returned 11.6% over the prior year, trailing our benchmark of the above three index funds which returned 12.9%. (All results shown below are thru 9-30-16)

In order to beat the benchmarks, we would have had to come close to or better than the return of VTSMX, which returned 14.9, for our domestic stock funds, and the 8.1 and 15.6 returns for VTMGX and VEIEX, respectively, for our international and emerging market stock funds. While our 5 international stock funds contributed better than a 10% return to their portion of the portfolio, our domestic stocks significantly trailed VTSMX. A big contributor to this underperformance was a long-time favorite, Fidelity Low-Priced Stock (FLPSX). It badly trailed other mid-cap funds, returning only 7.0 vs. at least 4 or 5 percent higher for its category average. Unfortunately, I feel the fund has become too similar to a growth-oriented fund instead of sticking to its prior successes as a value-oriented fund. I stopped recommending it as our July Portfolio.

Our Model Bond Portfolio returned 6.5% over the past year. This is considerably better than our benchmark, Barclays Aggregate Bond Index, which returned 5.2%. It is also ahead of the average US diversified taxable bond fund result of 5.5%. (Since our portfolio contains a muni bond fund, we adjust its return to approximate the equivalent taxable bond fund return.)

Our 1.3% outperformance was particularly enabled by the 9.8% return for Vanguard High Yield (VWEHX) and the 8.4 return for PIMCO Foreign Bond (USD-Hedged) Adm (PFRAX), the latter making up 25% of the our Bond Portfolio. We continue to highly recommend both these two funds.

Three Years Ago (Oct. 2013)

Our Model Stock Portfolio returned 6.6% over the prior three years. (All multi-year results are annualized.) This compares to a 7.0 return for our benchmark portfolio. The average diversified US stock fund returned 6.8, while the average international fund returned only 0.7.

Once again, the average return of our four international funds did better than the average return of our two benchmark international funds. And once again, FLPSX trailed badly our benchmark domestic fund, 10.3 vs. 6.7. Many of our remaining domestic funds did as well or better than the domestic benchmark, although our Value funds did somewhat worse. Our small commitment to the Vanguard Energy ETF (VDE) was our worst performer at minus 3.7, although it has bounced back strongly over the past year.

Our Model Bond Portfolio returned 4.3, beating out the benchmark which returned 4.0. We also easily topped the average US diversified bond fund which returned only 2.8.

Some our our highly rated picks, namely PIMCO Total Return Instit (PTTRX), PIMCO Real Return (PRRIX), and Loomis Sayles Retail (LSBRX) all underperformed the benchmark. However, Vanguard Intermed. Term Tax-Ex. (VWITX), with adjustment for the equivalent taxable bond fund return, as well as PIMCO For. Bond (USD-Hedged) Adm (PFRAX), and T Rowe Price Emerging Mkts Bond (PREMX) did extremely well, with returns in the range of about 6.5 to 7.0.

Five Years Ago (Oct. 2011)

Over a full five year period, my Oct. 2011 portfolio recommendations for both stock and bond funds beat their respective benchmark portfolios.

Our Model Stock Portfolio returned 14.0 over the prior five years. This compares to a 13.1 return for a portfolio consisting of our three benchmark index funds.

In order to beat the benchmark, we had to overcome the huge 16.2 VTSMX return with our domestic recommendations. Five out of these 11 funds succeeded in beating or nearly equaling that return. But what helped us the most was our smaller allocation to international funds, and, the outperformance of our international funds as compared to the benchmark international funds. While the benchmark always has a 35% allocation to international funds, our allocation was only 22.5%. All together, 9 out of the 14 specific Stock Portfolio funds beat the combined of 13.1 benchmark return.

Our Model Bond Portfolio returned 4.1 annualized over the prior five years, a full percent ahead of the benchmark; the average US diversified bond fund returned 3.4.

We were especially helped again by Vanguard High Yield (VWEHX) at 7.6, and this time by Loomis Sayles Bond Retail (LSBRX) at 5.8. Vang. Interm. Term Tax-Exempt (VWITX), as in each of the bond portfolios above also did well on a tax adjusted basis.

Bond funds that did particularly poorly were our inflation-adjusted funds and T. Rowe Price Intl. Bond (RPIBX).

All together, 5 out of 9 of the Model Bond Portfolio recommendations came out ahead of the bond benchmark.

Refer to the tables at the bottom of the page to see complete five year results for funds recommended in the Oct. 2011 Model Portfolios. While these funds were favored five years ago, none of stock funds listed, and only a few of the bond funds, are among our top favorites now; to see our current recommendations, please refer to our latest Oct. 2016 Model Portfolios.)

It Was a Very, Very Good Five Years: Part II

It's worthwhile every once and a while to stop and review the accuracy of our longer-term forecasts, not just for specific funds as above, but for more general appraisals of the investment backdrop.

In keeping with this month's theme, the following are quotes, condensed for brevity, from our prior Newsletters throughout 2011, which turned out to have been a very good year regarding what we were telling our readers.

From the Jan 2011 Newsletter (see it here): "We remain quite bullish on stocks prospects over the next several years, and especially over the next 5 to 10 years. Whenever we issue a recommendation, we are recommending that fund/category for periods of up to 5 yrs. or maybe even beyond. Frankly, we cannot really tell, nor are particularly interested, in what the next 3 to 6 mos. might hold for stocks. In fact, our long-term track record shows we have been most successful in predicting which categories of stock funds will do well after 5 full years; our 3 yr. record, while still quite good, is slightly less strong; the same is true for our 1 yr. record."

"Over the longer term, while there are never iron-clad guarantees, your odds of success should be quite high whenever you elect to invest when conditions, especially undervaluation, suggest that an asset category is below where history suggests it should be and economic fundamentals are improving. We believe we are in such an environment now." (underlining added)

S&P 500 then (12/31/10): 1,258
S&P 500 now (10/28/16):  2,126

From the Feb 2011 Newsletter (see it here): "Large Growth is the best category now, and Large Caps are a better place to be than smaller stocks or emerging markets." (underlining added)

Large Growth 5 yr. return from Jan. '11: 12.3% (ann.) Note: This was in fact the best return of all diversified fund categories.
Large Cap Blend returned 10.9
Small Cap Blend returned 8.3
Emerging Markets returned -4.6 (Average category data, annualized)

From the July 2011 Newsletter (see it here) "there are many highly troubling things one could find to possibly build a case that the stock market has already, and will continue to, lose its footing."

"The S&P 500 is up around 95% from its intraday low on March 6, 2009 (other indexes are up well over 100%) - such a huge move suggests caution if for no other reason than to be sure of locking in some profits."

"However, my fund category tracking research still shows virtually all categories as either HOLDs or BUYs. The S&P 500 Index itself has a price/earnings (PE) ratio of about 14 which shows that if anything, it is slightly undervalued (average PE down through the years is about 15)."

S&P 500 then (6/30/11): 1,321
S&P 500 now: 2,126

From the Aug. 2011 Newsletter (see it here) "Across the Board BUY Signals for Long-Term Investors In Effect"

"You might think that after all the gains since March '09, this would appear to be perhaps a very dangerous time to add to (or enter) the stock market. Yet, amazingly perhaps, the signals are now showing nearly all Buys as of 7/29/2011."

S&P 500 then (7/29/2011): 1,292
S&P 500 now:  2,126

From the Nov. 2011 Newsletter (see it here) "Obviously, no one can know whether a relatively high or low allocation to stocks will prove to be the better choice over the next year or two, or even longer. It [now] appears that more and more investors will be acting cautiously with regard to their stock positions."

"But time and again, the stock market usually confounds a logical analysis: Just when investors appraise the situation as particularly dire, good returns somehow appear, and vice versa. In my opinion, we are likely to be in just such a situation now." (underlining added)

S&P 500 then (10/31/11): 1,253
S&P 500 now:  2,126

Status of Funds Recommended Five Years Ago

Stock Funds

Oct. 2011 Stock Fund Model Portfolio
Five Year
Ann. Return
Status Now
(Nov. 2016)

Vanguard Growth Idx (VIGRX)
American Century Growth Inv (TWCGX)
Fidelity Blue Chip Growth (FBGRX)


Weak Hold
Weak Hold
Weak Hold

Vanguard Internat. Growth (VWIGX)
Vang. FTSE All-World ex-US Small-Cap
   Index (VFSVX)
Tweedy Brown Global Value (TBGVX)





Vang. Large-Cap Idx (VLACX)
Gabelli Asset (GABAX)


Weak Hold

Vanguard REIT (VGSIX)



Vang. Equity Income (VEIPX)
Yacktman (YACKX)
Vanguard Financials ETF (VFH)



Vanguard Mid-Cap Growth Index (VMGIX)


Weak Hold

Vanguard Small Cap Index (NAESX)


Note: Funds shown in bold returned ahead of the composite benchmark index return of 13.1%.

Bond Funds

Oct. 2011 Bond Fund Model Portfolio
Five Year
Ann. Return
Brief Appraisal Now
(Nov. 2016)

Vanguard Tot. Bond Market (VBMFX)


Govt. bonds not expected to do
well as rates rise.

PIMCO Total Return Instit (PTTRX) or
Harbor Bond Fund (HABDX)


Active management approach
can do well.

Vang. Interm. Term Tax-Exempt (VWITX)


Muni bonds last bastion for
reduced taxes in taxable accounts.

PIMCO Real Return Instit (PRRIX) or
Harbor Real Return (HARRX)


Better now that inflation likely to
gradually move up in years ahead.

Loomis Sayles Bond Retail (LSBRX)


Aggressive bond fund requiring continued
good economy to outperform.

Vanguard High Yield (VWEHX)


One of the best "junk" bond

T. Rowe Price Intl. Bond (RPIBX)


There are much better choices
out there.
Notes: 1. Funds shown in bold returned ahead of the bond benchmark index return of 3.1%.
2. VWITX return adjusted to show tax-equivalent return.
3. I only issue Buy, Hold, Sell recommendations for stock funds, not bond funds.


As a result of prior commitments, there will be no Newsletter next month (Dec.). The next Newsletter will be published around the end of Dec. and will include new 1st Quarter Model Portfolios for 2017.


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