Index investing is toast.

That's the new rallying cry among our friends who make their living off our unrequited love for superior returns.

It's also a case that's pretty easy to make. In 1999 and 2000 the average managed domestic equity fund beat the S&P 500 Index by 8.77 percent and 9.00 percent, respectively. Last year it was a near draw, with the average managed fund trailing the index by 0.36 percent.

So the stock picker's day has come.

If recent disappointments aren't worrisome enough, we are reminded that the S&P 500 Index is a capitalization-weighted index, which means that a handful of very large companies dominate the portfolio. General Electric, the most valuable company in the index at year-end, is worth some $397.9 billion, 17 times the $22.8 billion of El Paso, the 100th largest company, and 37 times the $10.6 billion of Loews's the 200th largest company. With the largest companies still sporting bull market multiples of earnings, book value, and cash flow in a purported bear market, the stock pickers are sure to cream the indexers over the next year.


But, we don't invest for a year. We invest for a long time. If I had only one choice to make for a long time, I would still be betting on the index.

You can understand why by considering a recent exercise. Morningstar--- the Chicago data and research firm that is the source of the figures used above--- divides the domestic equity fund universe into nine sectors. First they slice it into large, medium, and small capitalization stocks. Then they slice it into growth, blend, and value stocks. In any given period, there can be a reason for one sector to do better than another.

Last year, for instance, the winning sector was Small Value funds, with an average return of 17.28 percent. The losing sector was Large Growth. Those portfolios shed 23.6 percent of their value. The difference between Small Value and Large Growth for a single year is a whopping 40 percent.

With such figures you would surely think that we could find some long-term advantage to owning a particular sector, right? We should certainly find some advantage to finding a good sector picker. After all, if a manager can pick up as much as 40 percent in any year, why should we worry about paying him 2 or 3 percent?

Well, take a look at what happens over time.

Compare the different sectors over 5 or 10 years and the spread between the best and worst of the nine sectors is less than 4 percent. Extend the time period to 15 years and the spread is a less than 1 percent. That, in turn, is less than the premium we're asked to pay for skilled professional management.

But that isn't the whole story.

While the Vanguard 500 Index fund did poorly over the last two years, it beat all nine sectors over the last 15 years, trumping the best sector, Small Blend, by nearly 1 percent. (The figures for time periods from one to fifteen years are shown in the table below, including figures for the two Couch Potato portfolios.)
Look at the Long Road, Not at the Hood
Investment 1 year 3 years 5 years 10 years 15 years
Large Growth -23.6L -3.16L 8.24L 10.03L 11.81
Large Blend -13.58 -0.91 8.88 11.31 12.05
Large Value -5.38 2.32 8.84 11.88 11.89
Mid Growth -21.26 5.09 8.44 10.30 11.70L
Mid Blend -4.91 5.58 9.69 12.26 12.54
Mid Value 6.40 10.30 11.68 13.81 12.50
Small Growth -9.01 9.32 8.94 10.89 12.40
Small Blend 8.38 11.84 10.91 13.25 12.68
Small Value 17.28 13.02 11.29 13.47 11.97
Vanguard 500 Index -12.02 -1.06 10.66 12.84 13.56 H
Avg. Equity Fund -11.32 3.33 8.72 11.27 11.85
75/25 CP -6.91 1.22 10.29 11.68 12.30
50/50 CP -1.80 2.89 9.66 10.37 10.96
High-Low Spread 40.59 16.18 3.44 3.78 0.98
Source: Morning star Principia Pro, December 31, 2001 data; Scott Burns's calculations; bold type denotes the high, italic the low for the period, all figures in percent.
The superiority of the index is not black magic. It happens because the Index, however imperfect, captures most of the market capitalization in the U.S. market. While some stocks are plunging, others are rising. Entire industries can decline and the index will still perform relatively well. The longer the time period, the greater the odds that a manager will miss an industry that is rising and under perform.

Skeptics should consider the fact that energy stocks dominated the list in the early eighties and suffered as oil prices crashed. For all its over-weighting in the index, energy didn't prevent the index from providing superior returns over the next five, ten, and fifteen years.

It is likely to be so again, this time through the technology and telecom disaster. Bottom line: if you are making a primary choice, one that you will hold for a long time, funds that invest in major market indices remain a core choice and best bet in equities.