So asks Houston reader R.D. He wants what all of us want--- superior performance.
"A recent column discussed index fund returns versus average returns from actively managed funds. My question is based on the use of average returns.
"I have a difficult time setting goals to meet or slightly exceed average benchmarks. Average grades will not get you into college. An average job performance will not get you a promotion or a decent raise. Will the Dallas Cowboys be content to wind up the season as an average team? Should an investor risk his hard earned money to achieve average returns? writes R.D.
"Is it possible to beat an index fund with less risk by buying a managed fund without spending hours, months, or years in research? The answer is positively yes. It does not take much research to see where Vanguard Health Care Fund has beaten the corresponding index by a wide margin. Any one of the Dodge and Cox funds beat their corresponding index for 10 or more years. Fidelity Low Price Stock Fund is also in this category. The list could go on and on. I have not seen the research but imagine that at least 40 percent of all funds beat the index."
R.D.'s position goes a long way toward explaining how the investment industry wheedles billions in sales and management fees out of our money each year. All of us want superior returns. We want to do it ourselves. Or we want to find the asset manager who will do it for us. Or we want to have a kindly salesperson guide us to the superior manager. It ain't likely.
Let's start with the realities of managed investment performance. Then we'll ask three important questions.
Imagine managed mutual funds and index funds as students competing for grades and class standing. If you graded on a curve you'd give the top 10 percent an "A", the next 20 percent a "B", the next 40 percent a "C", the next 20 percent a "D", and the last 10 percent an "F." No one wants to invest in a fund that ranks only a D or an F. Few would be content with a "C."
In fact, 70 percent of all managed funds rank "C" or worse.
The Vanguard 500 Index Fund, on the other hand, has ranked no worse than the 48th percentile (a solid "C") over the last 5 years. Over the last 10, 15, and 20 years it has been in the top 14, 24, and 20 percent--- a very solid "B."
Vanguard Balanced Index doesn't have a 20 year record yet but it has ranked in the top 27, 35, and 25 percent over the last 3, 5, and 10 year periods. That's two "B"s and a "C plus," respectively.
Vanguard Total Bond Market Index fund has ranked in the top 49, 30, 21, and 33 percent over the last 3, 5, 10, and 15 year periods, respectively. That's a solid "B", a "B minus", a "C plus", and a "C."
The long-term performance of the major index funds, in other words, is better than "average." It may not be Dean's List, but it is superior.
One thing the managed fund sales force seldom mentions is that these grades only include those who finished the course or graduated. Mutual funds, like most courses and colleges, have dropouts. As investors, we only see the records of those who pass or graduate--- the biggest failures literally disappear. Result: the performance figures we see overstate the returns the average investor will experience.
Finally, portfolio managers change. In any ten-year period the average managed fund will have two managers. The second manager may not have the smarts (or luck) of the first.
If an index fund tends to rank at the 30th percentile, what are the odds that you'll select (or have) managers that score in the top 30 percent for a period of 20 years? You get the answer by multiplying 30 percent times itself four times--- once for each manager. Do the math and you have a less than 1 percent chance of making four successful manager changes. That's a real long shot.
Now let's ask the three questions.
First Question: Does superior performance continue?
Answer: Conspicuous examples tend to be the exceptions that prove the rule. Dodge and Cox Stock, frequently mentioned in this column but now closed to new investors, is one. A more typical example is Fidelity Magellan. After creating an incredible track record with Peter Lynch (and Ned Johnson earlier) the fund now trails the Vanguard 500 Index over the last 12 months, 3 years, 5 years, and 10 years. At 15 years it leads the index by all of 4 basis points--- that's 4/100ths of 1 percent. All the money and research talent at Fidelity hasn't been enough to keep this fund from sliding to a grade of "D" in the last 12 months, 3 years, and 5 years.
Second Question: Whom will the typical investor meet when advice is sought?
Answer: Odds are you will meet a salesperson that sells proprietary products. These are often funds with high expenses and mediocre track records. The odds of being advised into a fund that ranks better than "C" is well under 30 percent.
After that, your salesperson will change periodically. Each replacement will magically find superior selections that will generate new commissions. The majority of these folks are croupiers. They spin the wheel for the house. The house always wins. You might win, but it's improbable and incidental.
Third Question: Should you base your retirement plans on an unlikely event?
Answer: While striving for superior performance in our employment is reasonable, no sane individual should bet his or her retirement security on the flip of a coin--- or a less than 30 percent chance of beating an index fund.
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.
AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.