In the first six months of the year the average manager beat the index by 4.32 percent. Over the last 12 months ending June 30, the gap was even larger--- 11.61 percent. Indeed, the lagging performance continued in the month of July with the average fund losing 1.0 percent while the S&P 500 Index lost 1.9 percent.
The figures raise some serious questions, such as:
• Is the heyday of the Standard and Poor's Index funds over?
• Will Couch Potato investors, who have triumphed through years of carefully applied sloth, finally have to put down their mint juleps, rise from their hammocks, and start the grueling work of picking through the thousands of domestic fund offerings?
The answer to both questions: probably not. But the immediate future may not be as rosy as the last fifteen years. Let me tell you why.
The Case for Indexing Is Intact. Indexing started in the mid-seventies when researchers noticed that professional managers, as a group, regularly failed to beat the S&P 500 Index. Studies showed that about 70 percent of all managers would trail the index. There was great puzzlement over how so many smart people and could fail to beat a dumb index.
The answer, then, was costs. Even though the costs of running large institutional pension accounts--- the accounts that dominated the investment world at the time--- were small compared to the typical mutual fund, research indicated that professionals could not outrun the combination of their fees and the costs of transactions.
Today, the cost of a retail mutual fund is higher than the cost of running a large institutional pension account was then and portfolio turnover rates have soared. As a result, the overall cost of running a managed account has increased. Bottom line: the cost advantage that gave passive investing its edge is still in place.
It Will Be Difficult To Repeat the Last Ten Years. In spite of that, it will be difficult for S&P 500 Index funds to do repeat their performance advantage of recent years. One reason is that the index beat more than 75 percent of professionals in its category in each of the five years between 1994 and 1998 as new investors flooded into the market, buying visible names. It hasn't been below the 50th percentile against other managers since 1990. This is a very rare event.
Put it this way, among the well recognized funds that have done better than the index, most have only been in the top 25 percent of their category two or three years in a row. Yes, we're talking about funds like Janus Twenty, Fidelity Growth, AIM Constellation, and Vanguard Primecap.
The most likely future is one in which the S&P 500 Index funds rank in the second quartile rather than the top quartile as stocks outside the index do better than stocks inside the index. In other words, instead of only 1 in 5 funds beating the Index, it may be 1 in 3. Picking a better fund will be less of a long shot--- but it will still be against the odds.
Is there a simple, but still passive way to cope with the shift?
Indirectly, yes. The S&P 500 Index accounts for 75 to 80 percent of all market value in America. You can dilute--- but only dilute--- a period of relative under-performance by owning shares of a broader index. For instance, while Vanguard Extended Market--- the stocks NOT in the S&P 500 Index--- returned 16.53 percent over the last 10 years compared to 17.68 for the Index, it has returned 22.17 percent in the 12 months ending in June. That's three times the 7.31 percent return of the Vanguard 500 Index fund. Put them together and you have Vanguard Total Market fund. This fund trailed the S&P 500 Index fund over the last 5 years but is now pulling ahead. (see chart below)
A Seismic Shift in Investment Returns
|Period||Vanguard Index 500||Vanguard Extended Market||Vanguard Total Market|
|Last 10 years||17.65%||16.53%||NA|
|Last 5 years||23.76||20.29||22.08|
|Last 3 years||19.67||18.80||19.07|
|12 months ending June 30||7.31||22.17||9.87|