Buy a House

Call it the Automated Monkey Project. More than 30 years ago, a Richmond, Va.-based company, Media General, started an unusual project.  Their Portfolios Without Management was intended as a performance-measuring tool for Wall Street.

Media General programmed a mainframe computer to randomly select thousands of stock portfolios, calculate the performance results and then rank order the portfolios, in percentiles, from the best performer to the hindmost. They automated the old joke about having monkeys pick stocks by throwing darts at the financial page.

The result was embarrassing for professional money managers.

A majority of the randomly selected portfolios delivered higher returns than the pros. Like the earlier studies of institutional portfolios that led to the first institutional index fund, about 70 percent of the automated monkeys beat the pros.

Sometimes the pros did a little better. Sometimes they did a little worse. But the performance gap has existed for more than 40 years of research by multiple researchers. It was part of the 1980s. It was part of the 1990s.  And it is alive and well this century.

Today, if you visit the Standard & Poor’s website and check its SPIVA (Standard & Poor’s Indices Versus Active funds scorecard) page, you’ll find a list of reports going back to the third quarter of 2002. That report, in turn, measures performance from the third quarter of 1997.

The SPIVA report corrects performance measures for “survivorship bias”--- the tendency of average trailing returns to be higher than what most investors actually experienced. This happens because the funds with low returns disappear, like early cuts from a football squad.

And what is left? Only the better-performing funds.

Although few in financial services talk about this, one out of every four funds is likely to disappear over a five-year period. As a consequence, the five-year average performance figures are really averages of the “best three out of four” when 5 year performances are discussed. The other funds, like names on Gilbert and Sullivan’s Lord High Executioner list, “won’t be missed.”

Morningstar, now the standard in mutual fund performance reporting, doesn’t correct for survivorship bias. Its figures show the relative performance of the surviving funds for any time period. Even so, the Morningstar rankings consistently show that index funds regularly beat the majority of their managed competitors.

What’s true for equity funds is true in spades for fixed-income funds. The most recent SPIVA report shows that managed funds in only one of 13 fixed-income categories--- emerging market debt funds--- did better than the appointed index over the trailing five-year period. For the other 12 categories, the managed funds trailed their indexes from 64.7 percent of the time (global income funds) to a whopping 98.39 percent of the time (long-term government funds).

The Texas phrase “ain’t worth shooting” comes to mind.

Mix stocks and bonds, and the record is still terrible. Vanguard’s Balanced Index fund (ticker: VBALX) has done better than 85, 82, 77, 66 and 75 percent of its managed balanced fund competitors over the last 12 months, 3 years, 5 years, 10 years and 15 years, respectively, while charging investors only 0.19 percent a year.

Its long and dismal history notwithstanding, the mutual fund industry skims off billions of dollars in fees each year. According to a recent Investment Co. Institute study, for instance, 80 percent of all 401(k) plans have average expenses that range from 1.72 down to 0.35 percent. Workers in 403(b) plans often suffer far higher expenses.

Where does this money go?

It goes to feed the managers and the distribution system. It does not go to building more secure retirements for American workers. The difference in fees goes to build houses in the Hamptons, Nantucket, Jackson Hole and a few other spots favored by the very rich.

It doesn’t have to be this way.

The future of working people can be solved with a simple step: I call it plan B.

And what is plan B?

Cut the middleman’s take. Switch to index investing in 401(k) plans. The annual cost difference, which can be as much as 2 percentage points a year, will make a profound difference in your retirement security.

Next Sunday:  Part 3--- Building an inflation tilt into your retirement investments.

On the web:

Standard & Poor’s Indices Versus Active Funds Scorecards

Part 1 of this series:

Sunday, April 26, 2009: They Don’t Call Them 201(k)s for Nothing