Index Funds Lag for 7th Straight Year

Vanguard did a good job of convincing people to buy into their S&P 500 index fund, but was that advice wise? Jack Bogle, the company’s founder and most outspoken advocate, seems to make a decent case for Vanguard.

After getting crushed by their technology stock centric portfolios from 2000 through 2002 (The Nasdaq fell 80%), investors should just move what’s left of their nest egg into index funds. After all, few actively mutual managed funds can consistently beat the overall market indices. Why pay 1.5% per year for a lackluster managed fund when you get pay 90% less for Vanguard Index 500?

Not only do we hear this logic all the time, but millions of people have adopted the strategy. What do they have to show for it? Not much, according to Lipper, a leading tracker of mutual fund perfomance. For the 7th straight year actively managed U.S. stock mutual funds beat the S&P 500 index funds that have been marketed so heavily since the bubble burst.

So far this decade the S&P 500 has averaged a return of 0.2 percent per year. Actively managed frunds have returned 3.5% annually for their investors during the same time period. Some people may be surprised to learn this, but is it really that shocking? If active managers can’t beat a 0.2% return, that would be pretty pathetic. Still, annual gains that barely outpace inflation are certainly nothing that active mutual fund owners should feel all that happy with, so don’t think these funds are all of the sudden your best way to make good money.

The index fund argument completely ignores the entire point of investing; to buy low and sell high. To do so, investors must purchase attractively priced stocks, wait until they trade closer to fair value, and sell them. Then the process repeats itself. How does owning every stock in the country via an index fund accomplish this feat? By definition, it won’t. You’ll own undervalued stocks, fairly valued stocks, and overvalued stocks. Basically, you’re just crossing your fingers and hoping the stock market goes up. Too bad the bull market ended six years ago.

I don’t know about all of you, but banking your retirement on the hope that the market will go up is a risky proposition. Getting superior returns from index funds will solely depend on whether or not you happen to own them during bull markets or not. Unfortunately for investors, the greatest bull market in history ended in 1999. Pretty ironic considering that actively managed funds have outperformed the S&P 500 each and every year since, you guessed it, 1999.

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6 Thoughts on “Index Funds Lag for 7th Straight Year

  1. David Hopkins on January 12, 2006 at 2:19 PM said:

    My IRA’s are in index mutual funds. However, not one mimmicks the S&P 500. I have them split among an international index fund and a small/mid cap index fund. Over the long haul, small and mid cap stocks beat large cap (of which the S&P 500 is composed). And I do think that long-term, foreign markets will in general offer superior returns in comparison to the U.S. Having said that, I agree with your thesis, with qualifications. Unless one has the time and inclination to actively manage a portfolio, careful indexing, in my opinion, is a viable option. And now with the advent of ETF’s, very specific setor indexing can add to a portfolio’s return.

  2. Chad Brand on January 12, 2006 at 2:45 PM said:

    I guess it depends on your goal. If it is to slightly beat an S&P 500 index fund, then yes, small and mid cap index funds will accomplish that over the long term, albeit by a very small amount.

    Banking on international index funds outperforming domestic ones is purely speculation, as this historically has not been the case. Only time will tell if a shift takes place in the coming decades. It’s surely possible, but far from assured.

    Playing sectors via ETF’s really isn’t much different from index funds. Rather than an index based on company size, you’re dealing with an index based on company industry. In both cases, individual company valuation is completely ignored. It’s true that some sectors are cheap or expensive, based on historical data, at any given time, but ETF’s will still hold some undervalued stocks along with some overvalued stocks, thereby limiting upside appreciation potential.

    You are correct to point out that there are passive investment options that are superior to the S&P 500 index specifically. However, active management, by the investor directly or by someone else on their behalf, is a far better option than passive management so long as stock specific valuation is the focal point of the active strategy.

  3. David Hopkins on January 12, 2006 at 7:32 PM said:

    Chad,

    I just wrote a paper in my graduate Finance course on the Efficient Market Hypothesis. I essentially agreed with the theory. You have certainly given me pause! I should elaborate – I agree with the general hypothesis when the mutual fund industry is used as a proxy for the market. Fees, loads, scandal, etc. reduce returns and the average investor, in my opinion, when given the choice between a run of the mill large cap growth fund and the Vanguard 500 Index Fund, is better off in the index fund. Up until now, I have only used my marginal funds (monopoly money, if you will) to invest in individaul securities. I may have to rethink that strategy since I am a firm believer in value investing. As Warren Buffet has said (paraphrasing), if markets were efficient, I would be a beggar in the steet. Thank you for the valuable insights.

  4. SiamTwin on January 13, 2006 at 6:06 AM said:

    Chad,
    I would further your thesis by adding that with index funds (including ETFs), you are actually owning more of the overvalued stocks in the market/sector because if they fund is market cap weighted, which it usually is, then it is going to be overweight in the stocks which have risen more relative to the others, and these are likely to be more overvalued vis a vis their intrinsic worth.

    The newfangled “powershare” ETFs aim to remedy this situation, but you are still dealing with the index fund issues you so eloquently critiqued in your blog piece.

  5. Chad Brand on January 13, 2006 at 8:03 AM said:

    siamtwin –

    thanks for adding that element to the discussion. you are correct. market cap weighted indexes are kind of the opposite of dollar cost averaging. rather than getting more shares when prices fall, you actually get more as they rise, due to them being a higher percentage of the overall index.

    david-

    i won’t delve much into the efficient market hypothesis debate here (it would take way too long), but i will shares one of my favorite examples, if one were to argue against the EMH, which most of the world’s most successful investors do.

    back in 2000, palm was spun off from 3com. 3com sold 6% of the company in an ipo and held the remaning 94%.

    palm did well after it opened for trading, not surprising given the tech stock bull market. it’s market cap was $53 billion, with 3com’s 94% stake valued at about $50 billion.

    however, 3com’s total market value was only $30 billion. the market was giving the 3com business (without the palm division) a value of NEGATIVE $20 BILLION. needless to say, those who played that arbitrage ultimately made a killing. just one example of how the market is far from efficient.

  6. NO DooDahs on January 16, 2006 at 3:16 PM said:

    Two economists are walking down the street and one of them spots a $100 bill in the gutter. He mentions it, and the second economist says “that can’t be a REAL $100 bill just lying there – or else someone would have picked it up already.”

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