When you first stumble across this recent column from MSN Money, it seems that the writer (Tim Middleton) might just be playing an early April Fool's joke on his readers. After reading the the rest of the text, however, it's clear that he isn't--and this means that the joke really is on them.
"Just Beating The Market is Too Easy," the headline says. "Jack Bogle founded Vanguard Group on one simple premise: Indexing beats active management because indexes are less fallible than human managers. So how come this year everything -- small funds, large funds, gold funds, technology funds, energy funds, health-care funds and even utility funds -- is beating the S&P 500 Index?..."
Having hooked readers with a misleading question, Middleton goes on to explain part of an answer, which is that the S&P is primarily composed of large-cap U.S. stocks, while all of the funds above invest in distinct industry sectors or different asset classes altogether. Some industry sectors and some non-domestic-large-cap asset classes have in fact beaten the S&P so far this year (and will again next year, and the year after that, and so on)--a fact that merely demonstrates why investors are wise to diversify among multiple asset classes. What this year's performance does not even begin to demonstrate is what Middleton apparently finds so obvious that he is comfortable dismissing a half-century's worth of academic research with a wave of his hand: that passive investing, a.k.a., indexing, guarantees mediocrity and that, for those willing to show a bit of gumption, trouncing index funds is a piece of cake.
The only way to conclude that Middleton's argument is anything short of moronic is to assume that he equates "beating the market" with "beating the S&P 500" and that all "index funds" are designed to track the S&P 500. If one makes these two leaps, one might agree that simply buying an S&P 500 fund is not the best-possible solution for most investors. Even in this scenario, however, Middleton would still have some explaining to do (such as how he can conclude that buying the Vanguard S&P 500 fund guarantees "average" performance when almost every study in the past 50 years has shown that the vast majority of funds of any kind have lagged the Vanguard fund and that the fund has therefore delivered excellent performance.)
As the end of the column makes clear, however, Middleton is not content to just trash one of the best-performing mutual funds of all time: He wants to condemn the whole indexing movement. To wit:
...over longer periods, indexes do not compare favorably with above-average mutual funds, and they are shamed by really good ones. Here are examples:
Middleton then lists four indices--the S&P 500, the S&P Mid-Cap, the S&P Small-cap, and the MSCI EAFE International--followed by the "average" fund for each asset class and a couple of funds that have beaten the indices. In every case, not surprisingly, the "average fund" lagged the appropriate index in most of the time periods shown. Also not surprisingly, the top performers beat the indices.
So where's the error? As usual, in the omissions.
First, because Middleton has demonstrated after the fact that some funds beat their benchmarks, he wants his readers to believe that such funds would have been easy to identify ahead of time. Half a century of academic research suggests otherwise.
Second, although Middleton concedes (via the chart) that the "average" fund in each asset class lagged the index, he implies that investors still have a really good chance of picking a fund that beats the index. In reality, they have, at best, about 1 chance in three (and that's if they switch funds every year; if they are smart enought to invest for the long term, their odds are far lower). Middleton also ignores the fact that if investors fail to pick an index-beating fund, they will not get the index return. Instead, they will get a below-market return--sometimes WAY below market. As a result, choosing an actively managed fund has a negative expected outcome.
Third, despite beating the majority of professional money managers, the indexes that Middleton ridicules are not the state of the art. Since the mid-1990s, fund firms like Dimensional Fund Advisors and others have capitalized on the discovery that "value" stocks tend to outperform "growth" stocks--and, therefore, that indexes "tilted" toward value tend to do better than those that include a mix of value and growth. Like Middleton's after-the-fact winners, the smartest passive investors have trounced the S&P 500.
[Update: Some astute readers have pointed out that the "value effect" may not persist, especially now that so many investors have discovered it (see comments). Bogle himself takes this position.]
Is it possible to pick funds that beat the market, as Middleton suggests? Yes, it's possible. It's also unlikely, difficult, and risky (which, in most cases, makes it un-intelligent). And far from guaranteeing mediocrity, a diversified portfolio of low-cost index funds guarantees exactly what MSN's Middleton urges his readers to strive for: a solidly above-average return.
Thanks to David Boyum for passing on the link.