The Index Funds Win Again
Monday 27 April 2009
According to Mark Hulbert of NY Times, there is yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.
Basic stock market index funds generally aspire to nothing more than matching the returns of a market benchmark. In a miserable year for stocks, index funds may not look very appealing. But it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.
The evidence comes from a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. He presented his results in the Feb. 1 issue of Economics & Portfolio Strategy, a newsletter for institutional investors published by Peter L. Bernstein Inc.
Mr. Kritzman, who also teaches a graduate course in financial engineering at M.I.T.’s Sloan School of Management, set up his study to accurately measure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund. Those include transaction costs, taxes and management and performance fees.
He calculated the average return over a hypothetical 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualised return of 10 percent, an actively managed mutual fund with an annualised return of 13.5 percent and a hedge fund with an annualised return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages.
Mr. Kritzman found that, net of all expenses, including federal and state taxes for a New York State resident in the highest tax brackets, the winner was the index fund.
Specifically, he assumed that long-term capital gains were subject to a 15 percent federal tax and a 6.85 percent state tax; short-term capital gains and dividends were taxed at a combined federal and state rate of nearly 42 percent. The index fund’s average after-expense return was 8.5 percent a year, versus 8 percent for the actively managed fund and 7.7 percent for the hedge fund.
Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.
If such outperformance isn’t enough to overcome the drag of expenses, what would do the trick? Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.
The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.
But even that sobering statistic paints too rosy a picture, the professor said. That’s because it’s one thing to learn, after the fact, that a fund has done that well, and quite another to identify it in advance. Indeed, he said, he has found from his research that only a minority of funds that beat the market in a given year can outperform it the next year as well.
Professor Wermers said he believed that it was “exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone.”
“By definition, therefore, such a fund could not have been identified in advance,” he added.
The investment implication is clear, according to Mr. Kritzman. “It is very hard, if not impossible,” he wrote in his study, “to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And he said that those who still insist on an actively managed fund are almost certainly “deluding themselves.”
Study after study says the same thing, yet many investors do not hear the message from their advisers or fund managers…why? Because it's not in the sellers' best interest to tell their clients…simply because they, as fund managers or advisers will not make as much money!
Of course those fund managers that believe they can do better may prove to do so, but as the article says, how do you know which ones will do so in advance of their success? In fact with the large number of funds that fail to beat the market average, you are more likely to choose a fund that underperforms.
If you do have an actively managed portfolio of funds or a direct share portfolio managed by stockbrokers, perhaps it's time get the odds in your favour.
posted by Murray Round Wealth Management @ 10:49,
The Authors
Nicholas Round
Nic is the Managing Director of Murray Round Wealth Management Limited, who seeks to ensure the advice provided is truly independent. Based in Shropshire with clients local, national and worldwide, Nic has strived to find the best possible service for his clients needs, by researching and studying the market, trends and philosophies. Nic strongly believes Asset Class Management will bring his clients Financial Freedom, Independence and Happiness.
Kirsty
Kirsty is our communication guru. Managing information requires considerable due diligence and her passion for organisation gives the clarity we all seek. From Shropshire, with a Psychology Degree and much travelling, she is now back in Shrewsbury...and London often, keeping us all at Murray Round focused.
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