Do Indexes Beat Managed Funds?

I have some skill working with  numbers and there is a persuasive set of numbers that says index funds outperform managed funds.  Presumably because of fees.  I suppose I could believe that except:

  1. Indexes are averages and unless you understand the nature of the underlying population of events, averages do no not always have meaning.  The nature of averages is such that there will be some managers who outperform the index and there will be some who do worse.  Not everyone is average.
  2. The reason for buying and expecting to win seems circular.  Buying an index fund presumably increases demand for the securities in the fund and thus the price rises.
  3. The index is made up of all trades not just ones that have meaning to a long term investor.
  4. Stocks that fall out of the index do badly immediately after.  Funds dump the securities.
  5. The index includes trades made by non-professionals.  Why would I want my returns influenced by people operating on whim and emotion?
  6. Value investors look for price anomalies.  Index entry and exit provides those.  So do spin-offs.

I could also wish to believe the idea because:

  1. The index represents a big share of the economic fabric of the country.  I expect to be part of that economy for a long time and would like my investments to behave no worse than the country as a whole.
  2. I can be near brain dead and implement
  3. A lot of people believe these funds are better and when enough believe, it becomes self-fulfilling.
  4. They are macro, so easy to think about and talk about and there are no pesky specifics to be concerned about.
  5. They are boring and for a real investor that is a highlight.

There is no reason to accept, or be, an average manager of your long term investments. Look for managers who have been able to earn their fees and provide you with both yield and predictability.  Pay attention to the package design.  Some are more tax efficient than others.

Be very careful to avoid closet indexing in a managed fund. Paying big fees for an index fund is dumb.  It is difficult for a fund with a lot of money to avoid indexing.  There are not enough deals around to suck up their capital.  Berkshire Hathaway can do it because they buy large positions; often 100% of the business.  No investment fund does that.

Notice that most people don’t do better on their own. If they ignore the time and costs they will only seem to get better results.

As you would expect, some indexes beat some managed funds.

Investing is organized common sense.  In the long run you cannot overpay for a good business and you cannot underpay for a poor one.  The same deal as with teachers, doctors and bridge engineers.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com  705-748-5181

This entry was posted in Decision Making, Investing, Personal Finance and tagged , , , , , . Bookmark the permalink.

3 Responses to Do Indexes Beat Managed Funds?

  1. John Page says:

    Show me your evidence that managed funds beat indexes on a regular basis. Are you familiar with DFA? How about managed index funds?

    The reality is that most advisors and consumers continually underperform the indices. Your theory is good for you (maybe), but not 98% of the population.

  2. ronprestonjr says:

    Hi Don, I only invest in index funds and it is largely do in part to four facts.
    #1 The S&P 500 has never had a 15 year period that recorded a loss
    #2 Non managed no load index funds that are passively managed for periods greater than 5 years will always beat actively managed funds.
    #3 The market has proven that in the long-run the average real rate of return is 7% after inflation and expenses.
    #4 No actively managed fund has proven to provide consistent returns year over year. Top fund managers generate remarkable returns only to dive off the ledge the following year. It is simply random.

    FYI, my expense ratio is .17% in my VTSMX fund and it has an average annual return of 9% since 1992, and has brought a return of 14.5% over the last 3 years.

    check out my blog @ http://www.dearmoneyblog.com

  3. Patrick Keith says:

    It is entirely possible that some individuals can do better on their own with index funds.

    However a recent PricewaterhouseCoopers study shows that those working on their own accumulated less than half the net worth over 15 to 20 years of those working with an Advisor. And there are many money managers that have outperformed the index over the long term (I am not saying who other than retired managers such as Peter Lynch, Sir John Templeton and unreturned Warren Buffet).

    So if you are doing good and happy on your own. Great. But most people are not.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s