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Index funds have been touted by the Fool as an easy way for investors to invest. They don't require as much time and effort as investing in individual stocks and they usually have lower management fees than actively-managed funds.

Generally, I've always said that most investors (due to lack of time, lack of skill, or lack of interest) should be invested in index funds. But I have been doing some reading lately that has had me rethink the conventional "Foolish" wisdom.

There are two main reasons why an individual investor may not want to invest in index funds:

Reason #1: Index funds mean "buying high and selling low"

"Buy Low, Sell High" is a well-worn cliche' in Wall Street. But it is well worn for a reason. It is one of the only ways to consistently profit in the stock market, or any market for that matter. But index funds do not follow this philosophy. Take the S&P 500 for example. For a company to be added to this "club", it's market capitalization must be one of the largest 500 in the economy. In other words, its market cap had to have increased over some period of time. The only way for the market cap to increase is for the stock price of the company to go up. Likewise, for a company to be delisted from the "club", its market cap must go down below the 500th largest company (in market cap). In other words, its market cap, and its stock price, must go down.

So if you are running an S&P 500 index fund, the only stocks you can buy are those that are added to the S&P 500. Stocks that have gone up in price ("Buy High"). And the only stocks you can sell are those stocks that are removed from the S&P 500. Stocks that have gone down in price ("Sell Low"). This to me doesn't seem to be a very good long-term investment strategy.

Reason #2: Index funds haven't performed recently

The stock market enjoyed one of the biggest bull markets in its history from 1982-2000. Index funds, which followed the market, did well also. It was very hard to not do well investing in index funds during this period. But since 1999, the S&P 500 has had two down years. Alternatively, most value funds have done tremendously well, handily beating the market.

Why? I think we are returning to a new era of stock picking. Investors are becoming a lot more choosy about which stocks they invest in. An index fund can't be choosy. It has to invest in a stock, regardless of its fundamentals, as long as it meets a certain market cap. Remember, an S&P 500 index fund had to invest in Enron and JDSU and a host of other lousy stocks.

If we stay in a bear market or a directionless market for the next few years, the S&P 500 will stay down or flat for some time to come. Eventually all those statistics showing index funds outperforming actively-managed funds and individual investors will start to go away.

I see nothing wrong with an individual investor wanting to invest in an index fund, especially if they have no interest in the market. But I think the days of index funds being clearly a superior investment are done for now. If an individual investor really wants to generate high returns on their investments over the next several years, they would be wise to look into actively-managed value funds and learning how to invest on their own.

All the best,

CashPhlo
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CashPhlo,

You make some arguments that are compelling but could use a little data to back them up. Is there evidence that more actively managed funds beat the S&P 500 index in bear markets (more than just last year)? Is there evidence that actively managed funds do better in years of slower growth for the S&P 500? BTW the buy high sell low argument doesn't get you very far since the overwhelming majority of stocks in the 500 index remain year after year.

Mark
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No. of Recommendations: 6
Likewise, for a company to be delisted from the "club", its market cap must go down below the 500th largest company (in market cap). In other words, its market cap, and its stock price, must go down.

Not true. Many if not most of the companies dropped from the index are due to mergers and acquisitions. Since the stock price of an acquired company often jumps up when the acquisition is announced, a dropped company is often associated with a blessed event and a boost to the index.

If you think the S&P500 index has the disadvantages you describe, you can invest instead in the Total Market Index.

However, it is true that most equity funds have outperformed the S&P500 in the last couple of years, and the trend may continue or it may not. Investing in index funds is not a formula for outperforming anything. It is a formula for average performance with minimal risk.

Elan
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This look familiar, the general idea is similar to what financial planners say (except the invest on your own part : )
didn't TMF have one of their writers saying something similar recently?
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Cash Phlo:

Interesting theories. I'm afraid that I'm going to disagree with you on all counts, but I'm impressed at your thought process.

Reason #1: Index funds mean "buying high and selling low"

On a very superficial level this is true. But there are a few things to note about the logic you are using.

1. The S&P 500 is NOT the largest 500 companies by market cap. Berkshire Hathaway, for example, is not a member of the S&P 500, despite a market cap of $100 billion. There are, as we speak, about 800 publicly traded US companies with market caps exceeding $4 billion. 500 of these, we can assume, are in the S&P 500, but in no way should we assume that the largest 500 are all represented, nor should we assume that is the goal of the index. A company with much larger revenue numbers but lower market cap could get the nod for the index, there is NOTHING saying that the committee which manages the index must take the one with the higher market cap. There would be too much turnover if that were the case. Last year, 35 companies in the S&P 500 were changed, for a total of 7% of all equities.

2. but that's not the right way to look at it, because holdings are spread among the components in a marketcap weighted basis. The smallest 100 companies in the S&P comprise 1.99% of the total index value. In other words, LESS THAN 1% OF THE TOTAL VALUE OF THE S&P 500 WAS REPLACED LAST YEAR.

That is hardly a statistically meaningful ratio of buys OR sales to get exercized over.

3. So we have 99% survivorship bias among the holdings, which comprise of 84% of the entire US public company value by market cap. There is plenty of diversification here not to have to worry about the inevitable Enron or Lucent.

And besides, so what? Any portfolio should sell it's losers, and in one way the S&P has it right: more than 99% of its portfolio by value at the beginning of 2000 was still there at the end, creating almost no tax burden for those who hold products that are indexed to it.

Reason #2: Index funds haven't performed recently

This recent past performance has no bearing at all on what will happen from this moment going forward. This would be like saying in 1999 (which many people did) "dotcoms have beaten every other form of investing over the last two years, therefor dotcoms are a superior way to invest in the market".

I also don't believe that it is true. According to Lipper, 55% of all actively managed funds failed to beat the S&P 500 in 2001, despite the fact that the S&P had its worst year in 20 years.

These returns are net of fund fees, but not net of taxes. Seeing as the average mutual fund has turnover of 118%, those taxes in many cases will provide a substantial draw on those returns.

55% underperformance is the best performance that I have seen in a decade, with most years coming in between 70 and 85% underperformance, gross of taxes. These are extremely flimsy results upon which to state that the the age of index investing's superiority are over.

So, you're looking to find an actively managed fund that beats the market from this moment forward or looking to buy stocks yourself. I happen to believe that it is possible to do so, but it is not easy. I see no evidence at all that investors in general are being more choosy, I see scant evidence that the long seated advantage of the index fund over actively managed funds is going to evaporate.

That said, an adherence to value is probably the way to go, but most investors seem to be incapable of the discipline, and mutual fund managers have deep pressures to make quarterly benchmarks.

These are superior routes for the superior investors, but we can't all be superior, can we?

Bill Mann

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Thanks for the responses. I knew my post would be controversial since it was unconventional.

It is true that actively-managed value funds (particularly in the small cap arena) have outperformed the S&P 500 over the past couple of years. I agree that two years is probably too short a time frame to come to any conclusions. But historically, in bear markets and when the market is generally directionless, value stocks have outperformed. (http://www.stockcharts.com/commentary/scottmc/scottmc20001127.html)

As for my argument that buying index funds effectively means "buying high and selling low", I disagree that the S&P "reshuffling" has little impact. This article illustrates my point of the performance of stocks "kicked out" of the index and those brought in. (http://www.thestreet.com/funds/supermodels/10005285.html) This applies not only to the S&P 500 (that was just an example) but to all indices. This selection process creates a built-in bias towards momentum growth stocks and against value stocks. So it makes a lot of sense that when value stocks perform well, they beat the indices that are heavily weighted toward growth stocks.

I agree that index funds are a good way to get average performance with minimal risk. I just think that someone expecting to outperform the market may not want to invest in index funds without first investigating how index funds are "managed".

All the best,

CashPhlo
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According to Lipper, 55% of all actively managed funds failed to beat the S&P 500 in 2001, despite the fact that the S&P had its worst year in 20 years. [SNIP] 55% underperformance is the best performance that I have seen in a decade, with most years coming in between 70 and 85% underperformance, gross of taxes. These are extremely flimsy results upon which to state that the the age of index investing's superiority are over.

Hey, Bill - first, congratulations on your new role as Rule Maker manager.

Now then, on to a longstanding quibble I have had with the Fool's assessment of mutual fund performance. The fact that "X% of funds fail to beat the S&P 500" is often cited as evidence that individual investors would be better off managing their own portfolios. However, it isn't enough to know the proportion of funds that underperform the indices. After all, if 70% of managed funds underperformed the market by an average of 2%, but the other 30% outperformed the index by an average of 10%, then the individual investor would be better off choosing a diversified selection of managed funds rather than the index funds.

You might think this unlikely, of course - except that as Snoop has pointed out, the significant majority of individual stocks also underperform the market. Stock returns are skewed - a small number of very large outperformers skew the distribution so that the mean return is higher than the median return, and 70% of stocks underperform the market. You can read his analysis in the following thread.

http://boards.fool.com/Message.asp?mid=14687273

Thus, it would be perfectly reasonable for a significant number of managed funds to underperform the market averages even if managed funds overall equalled (or exceeded) the market's performance. After all, that's what happens with individual stocks.

Of course, we know from other literature that managed funds do underperform the market due to a variety of factors, particularly friction costs. But the fact that 70-85% of managed funds underperform (and you have a survivorship bias problem in there) does not itself show that the expected return from investing in managed funds is lower than for index funds.

Albaby
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It is true that actively-managed value funds (particularly in the small cap arena) have outperformed the S&P 500 over the past couple of years.


***

Interesting, too bad there aren't any passively managed small cap value index funds
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albaby:

Now then, on to a longstanding quibble I have had with the Fool's assessment of mutual fund performance. The fact that "X% of funds fail to beat the S&P 500" is often cited as evidence that individual investors would be better off managing their own portfolios. However, it isn't enough to know the proportion of funds that underperform the indices. After all, if 70% of managed funds underperformed the market by an average of 2%, but the other 30% outperformed the index by an average of 10%, then the individual investor would be better off choosing a diversified selection of managed funds rather than the index funds.

Very true. Where this can get hideously complex is that we not only need to review one year's worth of returns, we'd need to go on 5 & 10 year bases. Actually it's probably preferable to do so.

This of course gets us into the issue of survivorship bias. Datasnooper contends this skews the results and thus calls Lipper's data into question. I believe that it skews the results, but I would be hard pressed to be convinced that the funds that were folded had the propensity to be outperformers.

The problem, of course, is that the performance of one mutual fund has no bearing at all on that of another. This is to say that, OK, we have 70% that underperform by an average of 2% (these numbers are being manufactured), and a 30% that outperforms by an average of 6%. Those who select an underperforming fund gain no benefit whatsoever from the outperformance of someone else's fund -- their returns are completely detached from one another. This can also be said of individual stock portfolios, of course.

What I believe to be wrong is the statement that "X% of mutual fund underperformance means individuals can manage their own portfolios." I do not believe that there is any linkage between the two, and I believe that MOST investors should not manage their own ports. The trouble is in the definition. What is "manage your own portfolio"? Does it mean to buy an index fund? Does it mean that individuals can pick stocks better than the pros? Data showing individual stockpickers beating the pros is hard to come by, I've never seen any that I would really call rigorous, and thus I think that is a hideous leap of logic. Data stating that index funds on average beat the pros, well now we've got some data to go on. If "managing your own portfolio" means "buying an index fund", well then I believe that the data provided suggest that this is the case.

I know that Burt Malkiel has done some total expected return studies that show that total returns for funds were comparable to expected index returns, but not once fees and taxes had been calculated, especially over longer periods of time. The trouble with such studies is that there will always be other studies that show the opposite, but in general, I trust Lipper and Malkiel and believe that at a minimum that our usage of their results is consistent.

Thanks for chiming in, and thanks so much for your kind comments.
Bill Mann
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Interesting, too bad there aren't any passively managed small cap value index funds

http://screen.morningstar.com/etf/Lists/ETFStyleNameAscAllSmlVal.html

Elan
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Interesting, too bad there aren't any passively managed small cap value index funds

It depends on your definition of passive. Several funds have a turn over of less than 50% and have performed quite well for over 5 years. Wietz value is one of them. Its the only one I can think of off the top of my head because the kids' college money is tucked in it. But when I was reaserching I had a list of 6 or so that had low turn over, for a fund, and quality returns (over 20% with a beta less than 1) with a history over five years.

To way in further on the issue of funds. I do think it is possible to outperform the market, indices, with mutual funds. The thing is you have to research them as hard as you would your individual stock purchases, maybe even harder because of their turnover rate, and less on-line information available.

The argument stated above about the number of funds that underperform the market v. the ones that out perform is a good one. How many stocks out of the average year gain over 11%? Does anyone know? The whole premis of this web sight is that the individual investor can out perform the market if we learn the tools to do it. How do we out perform the market? In theory by weeding out the dogs and investing in the thoroughbred horses.

If our object is to outperform the maket than why should we handi-cap ourselves by throwing out a potentially valuable tool, like managed mutual funds. We should also consider that some funds can be bought, through the right brokers, with no load and no transaction fee. That saves you money up front compared to stocks.

The real pro indices funds argument is the one about people who don't have time to research either quality funds or quality stocks. They are the lowest maintenance, best chance of higher returns choice.

Finally, it seems most un-Foolish to automaticly throw out an investing opportunity (funds) just because 80% are dogs, if the the other 20% perform like thoroughbreds.
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Finally, it seems most un-Foolish to automaticly throw out an investing opportunity (funds) just because 80% are dogs, if the the other 20% perform like thoroughbreds.

do those 20% perform well year in and year out in up and down markets?
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No. of Recommendations: 5
Index funds haven't performed recently
I also don't believe that it is true. According to Lipper, 55% of all actively managed funds failed to beat the S&P 500 in 2001, despite the fact that the S&P had its worst year in 20 years.

I haven't seen the 2001 figures but if 55% of all actively managed funds failed to beat the S&P 500 it's likely that less than 50% failed to beat S&P 500 index funds. The reason is transaction costs that lower returns on S&P 500 index funds relative to the S&P 500. Although costs are small, the density on fund returns is high around it's mean. In other words it's likely that most actively managed funds returned more than S&P 500 index funds in 2001.

55% underperformance is the best performance that I have seen in a decade

Not the best I've seen because certainly most managed equity funds outperformed index funds in 2000. Some second hand Lipper figures I've seen suggest that 5,068 of 7,976, or 63.5% of all US equity funds returned more than the S&P 500 in 2000.

with most years coming in between 70 and 85% underperformance, gross of taxes. These are extremely flimsy results upon which to state that the the age of index investing's superiority are over.

Well except from the fact that managed funds have hammered index funds during the past two-year period the 1990s was a highly unusual period where large cap stocks outperformed small caps. Managed mutual funds by nature tend to hold portfolios that are less concentrated in large caps than the market making it extremely difficult to outperform when large caps dominate as they did in the 1990s - mutual funds have significantly improved in 2000-2001 because the large cap effect has disappeared and been replaced by relatively higher returns for small caps. Historically small caps have dominated so you certainly don't want to judge mutual fund performance based on the abnormal 1990s (see also the info albaby provided). Before 1990 there were sustained periods where actively managed funds outperformed index funds just like they do currently.

Datsnooper.
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Interesting, too bad there aren't any passively managed small cap value index funds

<><><>

I think Vanguard has one

Mark
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I know that Burt Malkiel has done some total expected return studies that show that total returns for funds were comparable to expected index returns, but not once fees and taxes had been calculated, especially over longer periods of time. The trouble with such studies is that there will always be other studies that show the opposite, but in general, I trust Lipper and Malkiel and believe that at a minimum that our usage of their results is consistent.

Perhaps, but there's always the Wermers study (1975-1994), which found that the stock selections of managed funds outperformed the market by about 130 basis points:

http://www.rhsmith.umd.edu/finance/rwermers/mutuals.pdf

Net returns of these funds underperformed the market index by about 1%. The stock outperformance was almost sufficient to outweigh the expense ratios and transaction costs, which reduced returns by 160 basis points; the balance of the underperformance was due to non-stock holdings within the funds.

Others have mentioned these findings before. I mention the study not to suggest that managed mutual funds are better than index funds - after all, Wermers found that such funds did, in fact, underperform "the market." However, there are some very important implications:

1) From 1977-1994, the average mutual fund provided returns net of higher expenses and costs exactly equal to that of the Vanguard 500 index fund [the different study period from the overall paper stems from different availability of data]. Thus, there is little empirical support for the suggestion that investing in an S&P 500 index fund provides superior returns than investing in managed funds. There are significant tax consequences, of course - but in tax-advantaged accounts, there's not as much difference as the "index fund industry" (tongue in cheek) would suggest. That leaves risk-adjustment, and you can't eat a risk-adjusted Twinkie (especially when your tongue is in your cheek).

2) Since any index fund is likely to have some transaction costs (Wermers cites an average of 30-40 basis points), the net underperformance of managed funds is going to be less than 1% annually. That's still not good, especially considering the tax consequences - but it paints a different picture than the oft-cited "70-85% of mutual funds underperform the market" comment. Moreover, it place your earlier comment that after a few years of managed fund outperformance, "I see scant evidence that the long seated advantage of the index fund over actively managed funds is going to evaporate." If you consider that index funds probably only had about 0.8% per year net advantage over managed funds going into those few years, it does start to seem more plausible that managed funds might outperform the index for some period of time.

3) Individual investors are facing a tough battle. Investing is not a zero-sum game, but outperformance relative to the market average is. If there are outperformers, then there must be underperformers. Wermers found that the managed funds are beating the market by 1.3% per year. They are paying too much for the knowledge, expertise, and transactions necessary to generate that outperformance... but they are outperforming nonetheless. Thus, we see the advantage that economies of scale and paying for information and analysis provide - and individual investors are competing in that environment. Since managed funds are outperforming the index, and index funds (by construction) are performing at the index, all other market participants must collectively be underperforming the index. Individual investors pay transaction costs too - and even if they approach the 30-40 basis points that the index funds incur, there is still an excellent possibility that the average individual investor underperforms the average managed fund.


Stepping back a moment, I have always been puzzled why TMF (institutionally) promotes the notion that individual investors can have an expectation of outperforming the managed funds. Individual investors may have little or no training in finance or business valuation, and have exceedingly limited sources of information; and should they pay to acquire either training or information, they have only their personal assets upon which to spread those costs.

I think that this belief stems from the Lipper figures. After all, if so many of the managed mutual funds keep losing year after year, then somebody must be winning, right? And if it's not the managed funds, and not the index funds, it must be the individuals, right?

Unfortunately, it appears that the 70-85% is just a reflection of the skewed distribution of stock returns, and that the stock picks of managed funds are beating the stock picks of individual investors. Even net of fees and expenses, the average managed fund has underperformed an index fund by less than 1% per year - and the fees/expenses don't go back into the pot. Despite the 70-85% figure, the average individual investor may not have a better-than-even-chance to beat the managed funds.


Albaby


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I know that Burt Malkiel has done some total expected return studies that show that total returns for funds were comparable to expected index returns, but not once fees and taxes had been calculated, especially over longer periods of time. The trouble with such studies is that there will always be other studies that show the opposite

Malkiel's study, which appeared in the Journal of Finance sometime in the mid 1990's, took issue with Lipper's figures that are full of survivorship bias. Lipper will typically only include funds that are still alive and thus their average returns are upwards biased - Malkiel measured this bias. While Lippers figures typically show average long run return performance for mutual funds in line with the S&P 500, Malkiel showed that real performance was less once accounting for survivorship bias. In some sense it is Malkiel that shows the opposite of Lipper.

This of course gets us into the issue of survivorship bias. Datasnooper contends this skews the results and thus calls Lipper's data into question. I believe that it skews the results, but I would be hard pressed to be convinced that the funds that were folded had the propensity to be outperformers.

This is a misunderstanding because it has nothing to do with the propensity for folded funds to be outperformers. Malkiel took issue with Lipper's return numbers that TMF doesn't (or at least rarely) mention, possibly because mutual funds don't look too bad with upwards biased returns. I took issue with the fractions of underperforming funds you mention all the time, among other things because the survivorship bias actually works against funds here. To see this suppose we had 1000 funds available ten years ago. 300 surviving funds outperformed the S&P, 300 surviving funds underperformed, while 400 folded. Lipper will then say that 30% outperformed the S&P 500 and you will say that 70% failed to beat the S&P.*** Now clearly funds that folded were more lilely to do so because of poor performance than good, but every single fund that folded with good performance with proceeds carried on to full-sample outperformance will improve your figures for funds regardless of how many folded because of bad performance. Moreover, every single fund that folded with bad performance gives rise to re-investment either by merging into another fund or buying a new, and some of these investment experiences will end up with market beating returns. We therefore know for a fact that your figures overestimate the fraction of funds that underperformed if they are to be interpreted in any meaningful way.

*** Interestingly Lipper could also say that 30% of funds underperformed the S&P 500 which TMF could turn to say that 70% of funds outperformed the S&P 500. This you don't do because it's not the story you wish to tell and I'll agree that it's further from the truth than the figures you give because of the greater propensify for dead funds to have performed poorly, but neither way is meaningful.


I trust Lipper and Malkiel and believe that at a minimum that our usage of their results is consistent

No you misunderstand the evidence because Lipper and Malkiel don't agree on the average return measures, and Malkiel doesn't address the bias in percentage of underperformers as discussed above.

Datasnooper.
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Interesting, too bad there aren't any passively managed small cap value index funds

http://screen.morningstar.com/etf/Lists/ETFStyleNameAscAllSmlVal.html

Elan


so if passive low cost alternatives exist is the original post really saying anything other than some parts of the market perform better than others from year to year and he can identify them (in retrospect)
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. . . Unfortunately, it appears that the 70-85% is just a reflection of the skewed distribution of stock returns, and that the stock picks of managed funds are beating the stock picks of individual investors. Even net of fees and expenses, the average managed fund has underperformed an index fund by less than 1% per year - and the fees/expenses don't go back into the pot. Despite the 70-85% figure, the average individual investor may not have a better-than-even-chance to beat the managed funds.


Well said
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do those 20% perform well year in and year out in up and down markets?


Here is a quick list of "value funds" all are no load and no transaction fee.
 I didn't research their annual costs or their turnover rates, just their returns.
 All of these are considered low to moderate risk (beta of 1 or less)

ticker       3Mo.     1yr.    5yr.    10yr.
oaklx          -3.64%   27.75%  27.87%
wpvlx          -7.74    5.48    20.74     19.2
wpalx          -7.19    6.58    18.58     18.16
rylpx           -.36    23.37   18.58
dmcvx            .91    18.68   17.48
umvex          -2.39    12.9    16.77
tcsvx          -6.92    34.12   16.76
amstx           -.05    5.28    16.75
umbix          -2.86    -.19    15.66
mypvx           1.94    17.84   14.93

This is a small sample and doesn't include growth funds which tend to have higher annual
 fees due to their high turnover rate. This isn't proof
 that any will do well next year. But that is as much the nature
 of the market and individual stocks, as it is the nature of funds.
 But you can see that in a down year for the indices most of these funds
 performed pretty well.

(disclosure: long on wpvlx)  

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Let me just make sure that I am understand what you are saying, albaby.

Net of fees and taxes, Wermer found that the underperformance of the average managed fund was about .8% of an index fund.

The index fund itself underperforms the actual index by .3-.4%.

So theoretically, on average if the S&P index were to return 11% in a year, the index fund would return 10.6 and the actively managed fund would return 9.8%. The actual numbers are not important - I'm trying to figure out what you mean on a relational basis.

Theoretically and generally speaking, is this an accurate characterization of what you are saying?

Thanks-
Bill Mann
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Net of fees and taxes, Wermer found that the underperformance of the average managed fund was about .8% of an index fund.

The index fund itself underperforms the actual index by .3-.4%.

So theoretically, on average if the S&P index were to return 11% in a year, the index fund would return 10.6 and the actively managed fund would return 9.8%. The actual numbers are not important - I'm trying to figure out what you mean on a relational basis.


Close, but not exactly. The average index fund has administrative expenses of about 30-40 basis points, so that fund would underperform the index by .3-.4%. The average managed fund underperforms the market (not the index fund) by a full percentage point.

Thus, if the market returns 11% per year, the market index fund would return 10.6-10.7% and the managed fund would return 10.0%, both net to investors. Thus, the relative difference between the two is about 0.6-0.7%.

At the margins, the lowest adminstrative fees seem to be associated with VFINX, which has administrative costs today of only 20 basis points or so. Since that index fund is available to investors, the relative difference is about .8%, and that's why I used that figure.

Th difference between managed funds and index funds (ranging from 0.6% and 0.8% on average) might certainly support a preference for the index funds. However, we're not talking about so large a discrepancy that it would be unthinkable, or even outlandish, to imagine that managed funds might outperform the index funds going forward.

In fact, Wermers found that from 1977-1994 the returns of managed funds and the Vanguard Index 500 Fund were identical. Why the difference from the numbers above? It's a slightly different time period (Wermers didn't have all the data for the Vanguard fund for the full 1975-1994 period of the overall study), Vanguard's fees were originally higher (from 46 in 1977 to 19 basis points today), and the S&P 500 is not the same as "the market" (the CSRP value-weighted broad market index).

As has been mentioned by others, the study also found that stock performance rose with the degree of turnover within the managed funds. This culminated in a finding that the average net return provided by high-turnover funds (the two highest quintiles) outperformed the S&P 500 index from 1976-1994 - 15.9% and 15.2% for the managed funds, compared to 13.8% for the index. That's the average net return, folks - and it runs counter to TMF's standard view of the relative merits of actively-managed funds and index funds. BTW - Wermers raises the question, but doesn't voice an opinion, as to whether this outperformance is wholly a compensation for risk.

Albaby
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<<As has been mentioned by others, the study also found that stock performance rose with the degree of turnover within the managed funds. This culminated in a finding that the average net return provided by high-turnover funds (the two highest quintiles) outperformed the S&P 500 index from 1976-1994 - 15.9% and 15.2% for the managed funds, compared to 13.8% for the index>>

This is an extremely important point that needs to be emphasized. Most of the "conventional wisdom" found in personal finance literature, and here on TMF, stresses a low-turnover approach as being key to beating the market. I couldn't disagree more strenuously. Really, when you stop to think about it, it's simple math. The market on average returns 10-11%. Yet, the annual volatility of the market is many multiples of that. Forget the market for a second. Take individual stocks. Even if you were an absolute genius and could identify in advance the greatest businesses to buy and hold, you are looking at 25 to 30% returns from that type of approach. In contrast, in this latest rally off the Sep lows, several stocks are up 100%+. Many stocks routinely swing that much and more. It seems quite obvious to me that "capturing some of the volatility" is the route to outperformance.

Can you catch the exact tops or bottoms of market or individual stock moves? H*ll no, no way unless you have a crystal ball. Can you catch decent portions of major intermediate moves in either the market or individual stocks? I don't think this is as impossible as some make it out to be. But that gets into learning alot more about TA and sentiment analysis, and being very particular about valuations you buy and sell stocks at.

http://biz.yahoo.com/p/mp/s/smcfx.html

This fund has a turnover of 175%. The performance numbers are just unreal (too bad its closed, this is one fund I'd actually put some of my money into). Excellent returns in completely different market environments. Point being I think the high turnover and performance are linked together.
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This is an extremely important point that needs to be emphasized. Most of the "conventional wisdom" found in personal finance literature, and here on TMF, stresses a
low-turnover approach as being key to beating the market. I couldn't disagree more strenuously. Really, when you stop to think about it, it's simple math. The market on
average returns 10-11%. Yet, the annual volatility of the market is many multiples of that. Forget the market for a second. Take individual stocks. Even if you were an
absolute genius and could identify in advance the greatest businesses to buy and hold, you are looking at 25 to 30% returns from that type of approach. In contrast, in this
latest rally off the Sep lows, several stocks are up 100%+. Many stocks routinely swing that much and more. It seems quite obvious to me that "capturing some of the
volatility" is the route to outperformance.

<><><>

Turnover = taxes and trading costs. I prefer the Buffet style of investing "bordering on sloth."

I randomly picked eight companies that might be rulemakers now that have strong brand recognition and had it thirty years ago. This was just a gee whiz pseudo dartboard pick the first eight that came to mind. PFE, KO, JNJ, GE and PG all outperformed the S & P index for the time period in question. MMM, GM and IBM did trailed. This small sample tells me that to beat the market average I just have to pick eight companies with strong brands buy stocks in them and ignore my portfolio until I retire. I'll only owe taxes on my dividends until then. I KNOW I can use this approach. I'm not sure you or anyone else can pick tops and bottoms in the market to profit from volitility.

Mark


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I randomly picked eight companies that might be rulemakers now that have strong brand recognition and had it thirty years ago. This was just a gee whiz pseudo dartboard pick the first eight that came to mind. PFE, KO, JNJ, GE and PG all outperformed the S & P index for the time period in question. MMM, GM and IBM did trailed. This small sample tells me that to beat the market average I just have to pick eight companies with strong brands buy stocks in them and ignore my portfolio until I retire.

That's not really kosher, of course. What you have essentially done is performed the following steps:

1) Screen all stocks for companies that you presently recall had strong consumer brands thirty years ago;

2) Select those that, 30 years later, have both survived and are among the dominant companies in their fields; and

3) Evaluate the returns from thirty years ago forward.

The key problems are Steps 1 and 2, where your analysis of investments available in 1972 is affected by your knowledge of which companies survived and flourished for the next 30 years. You're not considering copmanies with strong brands back when Nixon was president, such as Polaroid, Kodak, Xerox, AMC, et cetera. I can't even think of too many more, as they've faded from memory - but many companies that had significant brand penetration in the 1970's never made it to the 1990's.

In short - you already know the winners of thirty years of corporate competition, and you're just looking back to see whether those winners outperformed the S&P 500 average. No surprise that they did. That does not mean that picking companies that have strong brands and appear to be Rulemakers today will outperform the S&P 500 going forward.

If we had a list today of what companies would be Rulemakers in thirty years....ah, then we could just buy them and hold on for the ride. But that's a different test than the one you've constructed.

Albaby
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That's not really kosher, of course. What you have essentially done is performed the following steps:

1) Screen all stocks for companies that you presently recall had strong consumer brands thirty years ago;

2) Select those that, 30 years later, have both survived and are among the dominant companies in their fields; and

3) Evaluate the returns from thirty years ago forward.

<<><><>

I agree with you 100% its not kosher but then again neither is making up stories about how individuals could make a bundle reading charts and picking market bottoms and tops by looking back retrospectively. If I had picked a ten stock port with Kodak and Xerox in for instance I'd have 5 winners and five losers with the winners beating the index by more than the losers did. I suppose to be fair I should have included Bethlehem Steel and Wang computer as well making 7 losers and 5 winners and so on.

Why exactly is it that people who disagree with the RM approach are allowed to mine retrospective data to prove their point but I can't?

8)

Mark
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Why exactly is it that people who disagree with the RM approach are allowed to mine retrospective data to prove their point but I can't?

An interesting question - and as someone who watched the F4 debates rage on, one that is beyond my ken to answer appropriately and fully.

The problem with your analysis is not that it relies on past data, but that it filters that past data through "future data." Take the rather trivial, but wildly successful, Albaby Future Relative Strength Screen (AFRSS):

1) Take the universe of all stocks from 10 years ago;

2) Filter universe to identify those stocks that posted an RS>90 over the next 10 years.

The stocks identified by that screen will be wild outperformers - but of course you can't replicate that screen going forward, since you don't know what stocks will have an RS>90 for the next ten years. That's a subtle, but important, difference from identifying a universe of stocks in the past data based upon the known characteristics of those stocks at the time, and then examining what happens to those stocks going forward. [N.B. - that practice also has its detractors]

Albaby
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StringCheeseMark replies to my post:

<<I'm not sure you or anyone else can pick tops and bottoms in the market to profit from volitility.>>

In my ORIGINAL message I said:

<<Can you catch the exact tops or bottoms of market or individual stock moves? H*ll no, no way unless you have a crystal ball. Can you catch decent portions of major intermediate moves in either the market or individual stocks? I don't think this is as impossible as some make it out to be.>>

Well, no disrespect intended to you Mark, but I'm not quite sure how to respond when one either intentionally misquotes my argument and sets up a strawman, or just doesn't understand the language of my original post. I'm not sure I could have been any more emphatic about the difficulty of picking tops and bottoms.

At the risk of beating a dead horse, I will once again say PICKING EXACT TOPS AND BOTTOMS IS IMPOSSIBLE. Capturing portions of trends and market volatility is not. Whether one thinks it is worth one's time to learn the tools to do so is another matter entirely. FWIW (and I don't really like bringing up my port performance as an example, but you questioned it) my IRA port (no taxes and trading costs are low as I use a deep discount broker) was up 38% in 2001 utilizing to some extent a high turnover, frequent trading approach (but by no means at all a day-trading philosophy). In 2000 I was down 7% (still market beating) but utilized a less frequent trading approach. I won't necessary claim that proves anything, but we'll see how things go in 2002, 03, and 04.

There are plenty of indicators that have high correlations with market tops and bottoms, and when used in conjuction with each other stack the odds in your favor of getting good entry and exit points. Implied volatility levels are quite accurate at marking tops and bottoms (but not perfect, nothing is perfect). The ARMS index has a fairly good track record, and the Fed model points to relative valuation levels. The Value Line asset allocation model aint half bad either.

I'll give you an anecdotal example (of course one can make the argument this proves nothing but if that's your philosophy nothing I say will convince you). After the market reopened in September, and began to crash, by the end of the week implied volatility had skyrocketed to incredible levels. The ARMS index was SCREAMING to be bullish. The Fed model said the market was undervalued. There was an article in Barrons that the Value Line model had turned very bullish. And the crowd (dumb money) was very bearish. Based on this, I initiated long positions in QQQ, and a few other tech darlings. I didn't call the exact bottom, in fact all the positions, were briefly underwater. I've since liquidated all those trading positions (I still have some core LT positions) at substantial profit, and I didn't nail the top either. That's OK. I can live with that. I just captured 3-4 years of LTBH average returns in a few months. At this moment, implied volatility levels are low, and the crowd is overwhelmingly bullish (especially in techs). That tells me the upside in QQQ, INTC, AMAT, and all the rest isn't there now. If QQQ, INTC, and AMAT (which I still have a core position in) never go to their Sep levels again, thats OK, I'll look for opportunity elsewhere. But if they do, I'll have cash ready to scoop them up cheap again, and I'm sure I WON"T catch the bottom.

Another example. Good old Merck, which I think is a Rule Maker. Look at its stock price volatility. It's ridiculous. The actual business volatility nowhere near matches the stock price volatility. This provides opportunities to trade Merck effectively. A little over a year ago, the market friggin loved Merck and it was trading at around 100. Now, nobody loves Merck and its down around 60. It's at a discount to the S&P, and most importantly at a discount to the historical P/E and P/S ratios it typically trades at. Now is the time to be buying MRK. Then, 1, 2, 3, whatever, years from now when the market loves MRK again and bids the P/E and P/S levels to a premium again, you unload maybe all, or just a portion of your MRK holdings. Then you wait, and you wait, for the market to not like MRK again.

There's a whole host of stocks that can be played this way, and really they are the Rule Maker type stocks. The thing with these Rule Maker type stocks, is, well, everybody knows they are Rule Makers, so your return is going to be pretty much determined by the price you pay for them. You've gotta be patient. You have to wait for that brief opportunity when the market takes some short-term blip of a problem, and drastically reduces the multiple on the stock. AXP, WMT, PFE, etc.

You buy AXP in the 20s and 30s, not the 60s. You buy WMT at 40, not 60. If WMT never hits 40, well, look for something else. Again, you are not going to buy AXP at the absolute bottom of low 20s, but you avoid being stupid and buying it when it is 60ish.

I'm not trying to argue just to argue, but to bring a different perspective. There is a middle ground between LTBH at any price and day trading for sixteenths, and that's where IMO the most opportunity lies, but if what you are doing works for you, stick with it and good luck.
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Close, but not exactly. The average index fund has administrative expenses of about 30-40 basis points, so that fund would underperform the index by .3-.4%. The average managed fund underperforms the market (not the index fund) by a full percentage point.

Thus, if the market returns 11% per year, the market index fund would return 10.6-10.7% and the managed fund would return 10.0%, both net to investors. Thus, the relative difference between the two is about 0.6-0.7%.

At the margins, the lowest adminstrative fees seem to be associated with VFINX, which has administrative costs today of only 20 basis points or so. Since that index fund is available to investors, the relative difference is about .8%, and that's why I used that figure.

Th difference between managed funds and index funds (ranging from 0.6% and 0.8% on average) might certainly support a preference for the index funds. However, we're not talking about so large a discrepancy that it would be unthinkable, or even outlandish, to imagine that managed funds might outperform the index funds going forward.


OK, good, so we're talking about the average index fund and the average managed mutual fund. Stipulating of course, that we are not compensating for risk. But is a difference of .6% per year good enough?

The framing, of course, is to look at what that equates to over a long term.

I have the returns from the S&P 500 from 1966 to 2000. Let's use these average numbers on real data and extrapolate what a .6% underperformance per year is worth over the long term. (I think you are using .8, but I can't really tell)

To calculate, I am subtracting .3% (30 basis points) from the S&P 500 to compute annual index fund returns, then subtracting a further .6% (60 basis points) to determine the returns of an average mutual fund. I'm starting at the beginning of 1966 with two portfolios worth $10,000.


S&P Index Avg. Fund Index Return Avg Fund Return
1965 10% 9.7% 9.1% $10,970.00 $10,910.00
1966 -11.7 -12 -12.6 $9,686.51 $9,535.34
1967 30.9 30.6 30 $12,679.64 $12,395.94
1968 11 10.7 10.1 $14,074.40 $13,647.93
1969 -8.4 -8.7 -9.3 $12,892.15 $12,378.67
1970 3.9 3.6 3 $13,394.95 $12,750.03
1971 14.6 14.3 13.7 $15,350.61 $14,496.79
1972 18.9 18.6 18 $18,251.87 $17,106.21
1973 -14.8 -15.1 -15.7 $15,550.60 $14,420.54
1974 -26.4 -26.7 -27.3 $11,445.24 $10,483.73
1975 37.2 36.9 36.3 $15,702.87 $14,289.32
1976 23.6 23.3 22.7 $19,408.74 $17,533.00
1977 -7.4 -7.7 -8.3 $17,972.50 $16,077.76
1978 6.4 6.1 5.5 $19,122.74 $16,962.04
1979 18.2 17.9 17.3 $22,603.08 $19,896.47
1980 32.3 32 31.4 $29,903.87 $26,143.96
1981 -5 -5.3 -5.9 $28,408.68 $24,601.47
1982 21.4 21.1 20.5 $34,488.13 $29,644.77
1983 22.4 22.1 21.5 $42,213.47 $36,018.40
1984 6.1 5.8 5.2 $44,788.50 $37,891.35
1985 31.6 31.3 30.7 $58,941.66 $49,524.00
1986 18.6 18.3 17.7 $69,904.81 $58,289.74
1987 5.1 4.8 4.2 $73,469.95 $60,737.91
1988 16.6 16.3 15.7 $85,665.97 $70,273.77
1989 31.7 31.4 30.8 $112,822.08 $91,918.09
1990 -3.1 -3.4 -4 $109,324.59 $88,241.36
1991 30.5 30.2 29.6 $142,668.59 $114,360.81
1992 7.6 7.3 6.7 $153,511.41 $122,022.98
1993 10.1 9.8 9.2 $169,016.06 $133,249.09
1994 1.3 1 .4 $171,213.27 $133,782.09
1995 37.6 37.3 36.7 $235,589.46 $182,880.12
1996 23 22.7 22.1 $289,775.03 $223,296.63
1997 33.4 33.1 32.5 $386,559.89 $295,868.03
1998 28.6 28.3 27.7 $497,116.02 $377,823.47
1999 21 20.7 20.1 $601,510.38 $453,765.99
2000 -8.1 -8.4 -9 $546,772.94 $408,389.39
2001 -11.1 -11.4 -12 $486,081.14 $359,382.66

So, over this period, with the difference between the average mutual fund and the index fund set at .6%, the difference is $126,698. More importantly, the difference is a full 35%.

So you're asking me why we say that there is relative merit between the index fund and the actively managed fund, I'd say that those small numbers add up over time.

Am I saying that there are NO actively managed funds worth owning? Well, no. In fact, we've produced some lists of funds that we really like. In a tax deferred account, there may be some real benefits to certain funds (none of these "certain funds" happen to be available in MY 401(k) plan, though.) If we're talking about a taxable account, well, given the fact that VFINX has only had a taxable distribution once in its history, I submit that the tax implications will not appreciably help the case for active management.

(By the way, did you notice that one of the people Wermers thanks in his report is named "Bill Ding"? What a cool name!)

To be reviewed and revisited, for sure. Again, I'm not sure how the message ended up with "manage your own portfolio and kick the crap out of the professionals!", because I don't think that's an accurate depiction. I do think that on a net-net return basis pointing investors to an index fund is extremely sound and tax-efficient advice.

Thanks, albaby, and thanks for the link to the Wermers study. Too bad his name reminds me of Animal House. "We have a Dean Wermer at Faber!"

Bill Mann

"I only know two songs. One is "Yankee Doodle Dandy and the other one isn't." -- Ulysses S. Grant
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So, over this period, with the difference between the average mutual fund and the index fund set at .6%, the difference is $126,698. More importantly, the difference is a full 35%.

You are abusing the data big time here. Wermers used a 19-year sample from 1976-1994 to compute the .6% average annual difference between index and managed funds returns. Judging from the variability of the S&P 500 returns you present the standard deviation of this average return difference is at least 1%. This means that we can't reject that managed funds don't underperform index funds at any meaningful statistical level of significance. You then take a .6% return difference that's indistinguishable from zero and compound it when it's nearly as likely that managed funds really outperform index funds by that figure. You are doing something that's not too different from projecting the result of ten successive coin tosses to be all tail based on a single trial toss that yielded tail. This is massive abuse of the data and I don't understand why you are doing it. Shouldn't this be more about enlightening your readers than twisting the evidence to tell a story that fits you. But let see how your example works out comparing the return on the managed funds with highest turnover to index funds where the former returned about 2% more per year, a figure that, unlike the .6%, is statistically significantly different from zero:

High High
S&P Index turnover Index fund turnover
Index funds funds balance Balance

1965 10.00 9.70 11.7 $10,970.00 $11,170.00
1966 -11.7 -12 -10 $9,653.60 $10,053.00
1967 30.9 30.6 32.6 $12,607.60 $13,330.28
1968 11 10.7 12.7 $13,956.61 $15,023.22
1969 -8.4 -8.7 -6.7 $12,742.39 $14,016.67
1970 3.9 3.6 5.6 $13,201.12 $14,801.60
1971 14.6 14.3 16.3 $15,088.88 $17,214.26
1972 18.9 18.6 20.6 $17,895.41 $20,760.40
1973 -14.8 -15.1 -13.1 $15,193.20 $18,040.79
1974 -26.4 -26.7 -24.7 $11,136.62 $13,584.71
1975 37.2 36.9 38.9 $15,246.03 $18,869.17
1976 23.6 23.3 25.3 $18,798.35 $23,643.07
1977 -7.4 -7.7 -5.7 $17,350.88 $22,295.41
1978 6.4 6.1 8.1 $18,409.28 $24,101.34
1979 18.2 17.9 19.9 $21,704.54 $28,897.50
1980 32.3 32 34 $28,650.00 $38,722.66
1981 -5 -5.3 -3.3 $27,131.55 $37,444.81
1982 21.4 21.1 23.1 $32,856.30 $46,094.56
1983 22.4 22.1 24.1 $40,117.54 $57,203.35
1984 6.1 5.8 7.8 $42,444.36 $61,665.21
1985 31.6 31.3 33.3 $55,729.45 $82,199.72
1986 18.6 18.3 20.3 $65,927.94 $98,886.27
1987 5.1 4.8 6.8 $69,092.48 $105,610.54
1988 16.6 16.3 18.3 $80,354.55 $124,937.26
1989 31.7 31.4 33.4 $105,585.88 $166,666.31
1990 -3.1 -3.4 -1.4 $101,995.96 $164,332.98
1991 30.5 30.2 32.2 $132,798.74 $217,248.20
1992 7.6 7.3 9.3 $142,493.05 $237,452.28
1993 10.1 9.8 11.8 $156,457.37 $265,471.65
1994 1.3 1 3 $158,021.94 $273,435.80
1995 37.6 37.3 39.3 $216,964.13 $380,896.07
1996 23 22.7 24.7 $266,214.98 $474,977.40
1997 33.4 33.1 35.1 $354,332.14 $641,694.47
1998 28.6 28.3 30.3 $454,608.14 $836,127.89
1999 21 20.7 22.7 $548,712.02 $1,025,928.93
2000 -8.1 -8.4 -6.4 $502,620.21 $960,269.48
2001 -11.1 -11.4 -9.4 $445,321.51 $870,004.15

So instead of the 35% outperformance you report that is unreliable, we get nearly a 100% outperformance some of which can be deemed likely reliable. Think about this, with your logic:
MUTUAL FUNDS WITH HIGHEST TURNOVER HAVE RETURNS THAT ON AVERAGE ARE TWICE AS HIGH AS INDEX FUNDS!
How's that for a match with the Fool's message?

Am I saying that there are NO index funds worth owning? No I'm not, only that the Fool's and your view on the subject matter is flawed.

Datasnooper.

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PFE, KO, JNJ, GE and PG all outperformed the S & P index for the time period in question.MMM, GM and IBM did trailed

Have to disagree on the perfomance of KO. It has pretty much done nothing over the past 3 years and is currently selling within 5% of 5 year lows. IBM over the past 5 years has a CAGR of around 24 1/2%, trailing only PFE's 25%


Gary
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I wrote: This means that we can't reject that managed funds don't underperform index funds at any meaningful statistical level of significance.

To further show this I have average annual returns of all US mutual funds during the period 1962-2000 including dead funds from CRSP. While the data is clean in that there's no survivorship bias it includes all funds, i.e. not just equity funds but also bond and money market funds. As a result returns of equity funds should be slightly higher. The annualized return was 9.9% vs 11.2% for the general US stock market. The average difference in log-returns was 1.17% with a standard deviation of 0.90%. Therefore the underperformance of mutual funds during the 39-year sample was so weak that we can't even reject that mutual funds don't perform identically to the market at usual significance levels. The evidence becomes even weaker considering that index funds have expenses that need to be subtracted from the market return, and non-equity funds need to be excluded from average fund returns. Granted the average mutual fund return includes index funds but the efftcts of that are minor, expecially considering that for a good part of the sample there were no index funds.

We just don't have enough evidence to say that managed funds underperform index funds, period. There's no other possible conclusion.

Datasnooper.
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And I'm saying that over time an annual .6% underperformance is significant. Did anyone at any time EVER insinuate that there was a static return on the S&P 500? No, that would be stupid, and easily refuted with actual historical returns.

Obviously there is nothing that says the S&P returns 11% per year. Obviously there is no data that says that x number of mutual funds under or overperform the S&P each year, guaranteed. There is either an average underperformance or there is not. No one seems to be able to agree whether this is the case, and yet you seem to want us to believe you have all the facts and thus yours is the only valid opinion in the matter.

Which study does one listen to? Which one do you believe? Wermers? Fama's?

When Gruber discusses a 65bp annual underperformance by the average mutual fund, why should one not take those 65bps and see what they would correlate to using a model portfolio? Of COURSE it is generalized, but he is talking about AVERAGE annual returns, so it is not abusive to use that data and extrapolate it. And if a 65 bp average annual underperformance is meaningful enough for Grubers to bother to publish a report about it, then it has relevence, even if the guys in math lab discount it as being indistinguishable from zero.

Why didn't Gruber just say "well the difference is not statistically meaningful, on average"? Wow, that's some report. Stop the freaking presses. The coin flip guys have just been taken out back and shot!

Because an annual 65 bp IS meaningful in the real world, even if it is not statistically so, which is why the results changed using VFINX when they dropped their fees from 46bps to 19. If it's not distinguishable from zero, then WHY DID IT MATTER?

And finally, let's look at the final quote in Wermers' study: "Finally, all of our results ignore the higher tax burden of actively managed (especially high turnover)funds. Of great current interest is whether managers of actively managed funds add value net of taxes."

From a probability standpoint that tax considerations do not assist actively managed funds, I think I'm standing on much firmer ground than you are allowing.

In the end, the single most important thing to investors is that net return number. Not one year return, but compounded. Not just whether fund managers were good stock pickers, but what the bottom line was, net of taxes, fees, loads and expenses. So while this academic exercise is entertaining, it in no way provides any evidence at all that net of all of these things that there is a positive effect for actively managed funds, whether high turnover or not. Bogle has always used tax efficiency as part of the benfit of index funds, so it bears little practical purpose to say that he is wrong if you ignore the tax consequences of active trading.

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MDCigan,

Sorry for the misunderstanding. I failed to understand what you meant by not being able to predict tops and bottoms on one hand and the implication that doing so would lead to better returns. Frequent trading clearly has benefits and hazards. On one hand buying stocks when the crowd has over-reacted (Sept 11 or any other war scare for that matter) is often a great way to get good stocks on the cheap. OTOH frequent trading increases the chances that you make mistakes. My personal approach is to research my buys and sells extensively and make fewer trades.

Your overall philosophy of waiting until good companies become undervalued and then unloading at least part of your position when they become ridiculously valued makes a lot of sense particularly when you are investing in established more slowly growing companies. I'm selling the last of my Cisco for this reason. There is no way its going to grow fast enough to justify its valuation. I'd rather have GE or Pfizer at a 10-25% discount to intrinsic value than uncertain growth at any price.

Mark
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Have to disagree on the perfomance of KO. It has pretty much done nothing over the past 3 years and is currently selling within 5% of 5 year lows. IBM over the past 5 years has a CAGR of around 24 1/2%, trailing only PFE's 25%

<><><>

I was refering to price appreciation over the last 30 years. Cokes lackluster performance for the last five has not allowed the S&P 500 to catch up from to KO's gains during the previous 25. It still was a bad example since one could have easily picked a port with a group of "nifty fifty" stocks that turned out to be losers.

Mark
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<<Because an annual 65 bp IS meaningful in the real world, even if it is not statistically so, which is why the results changed using VFINX when they dropped their fees from 46bps to 19. If it's not distinguishable from zero, then WHY DID IT MATTER?>>

The point I think Snoop is making (and I'm sure he'll correct me if I'm wrong <grin>) is that this PAST 65 bp difference between actively managed funds and index funds measured over that time frame has ABSOLUTELY NO RELEVANCE WHATSOEVER as to whether a 65 bp difference will exist in the FUTURE between actively managed and index funds over the same time frame. We simply do not know with any level of statistical confidence. In this case, the past has no implications at all for telling us what will happen in the future. Therefore, at best it is meaningless, and at worst extremely misleading, to project this difference going forward compounded, and say, "Hey, look how much more money you have at the end with the index fund."

Regarding the whole tax issue, and the effect of taxes on net returns, the thing I think you and many here are missing, is that for the majority of investors (especially the middle tier in terms of amount of wealth) a large portion of their investment holdings are likely to be in IRAs and 401(k)s so any tax issues are essentially irrelevant.
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Mark,

No prob. We're probably not that far apart on our thinking.

<<Frequent trading clearly has benefits and hazards>>

Agreed. And I think it largely depends on the individual. I think you have to have the right emotional/psychological temperament to make more frequent trading work for you. I think if you are good, you can add value above just buying and holding and if you aren't, you are probably gonna end up decimating your portfolio.

How many people do you think sold off stocks right after 9/11 because of the FUD surrounding the economy and the market in light of the terrorist events? How many advisors, gurus, and analysts were advising caution and remaining on the sidelines until things looked "clearer". How many of those same people are now buying back stocks at much higher levels, and how many of those same advisors, gurus, and analysts are now bullish because the "recovery" is just around the corner? It's the natural tendency of us humans. Avoid fear and uncertainty, and join the crowd when its comfortable. Unfortunately, its the @$$ backward thing to do.

I'm not sure if you mentioned GE just as a potential idea, or you actually own it. If you own it, I'd take a good long look at it. I think it is where KO was 5 years ago. At best, you are looking at flat performance, and at worst negative returns over that time frame. First off, a large portion of GE's profits comes from its finance division, and I have a feeling there could be problems there in the near future. More importantly, take a look at its total return over the past 5 years. How much of that was dividends and earnings growth, and how much was multiple expansion? The vast majority was multiple expansion. That isn't a sustainable source of returns. Multiples tend to revert to their mean values. Look at 20 years of GE P/E multiples, and compare the current multiple to that range. Furthermore, given GE's enormous market cap and revenues, how realistic is it for GE to grow revenenues and earnings at 15% annually? How much more cost cutting can they do? I could be wrong, but at the moment GE looks like a bad bet.

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for the majority of investors (especially the middle tier in terms of amount of wealth) a large portion of their investment holdings are likely to be in IRAs and 401(k)s so any tax issues are essentially irrelevant.

Actually, just 35% of "total investment" is in "retirement accounts". When you consider that most 401(k)s don't offer the flexibility to invest in individual issues, you would find that only a small fraction of "available retirement money" can be invested in "stocks", per se, rather than "funds".

For many of us, perhaps most, "tax issues" are large indeed.
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. . . but he is talking about AVERAGE annual returns, so it is not abusive to use that data and extrapolate it.

Ah, yes. Nothing like rewriting the rules of statistical theory.
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Nothing like rewriting the rules of statistical theory.

I thought that was how statistics was supposed to work. At least in medicine it does.

Samhain - who has never eliminated an outlier he didn't like.
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No. of Recommendations: 32
There is either an average underperformance or there is not. No one seems to be able to agree whether this is the case, and yet you seem to want us to believe you have all the facts and thus yours is the only valid opinion in the matter.

No you're looking at this from the wrong perspective. Suppose the population (long run) difference in returns between index funds and actively managed funds is X% per year ***. The population includes all past and all future years. Unfortunately we don't know X (obviously), can't even agree whether it's positive, negative or zero, but decide to estimate it, i.e. letting data tell us. We collect data for one year, 2000, where the average mutual fund outperformed the market by 12 percentage points (actual figure). Here's the conversation that follows:

Snoop: OK, our best guess is that X=-12

Otter: Come on you can't measure the population from one year where managed funds were lucky. We need to consider more years that's sound statistical practice.

Snoop: OK I collected data for 1999 also and funds underperformed by 3%. Now the average X (ignore compounding) is (-12+3)/2=-4.5.

Otter: No, no, no. No! we need more information. The statistical uncertainty on your 4.5 figure is huge.

Snoop: Alright let's include 1998 where funds underperformed by 7%. We now have X=(-12+3+7)/3=-0.67, so you see managed funds still outperformed.

Otter: This is annoying. You know very well that we need to collect as much data as possible. We also can't judge the rule maker portfolio based on a few years right?

Snoop: (albaby actually) Right. Russ Wermers collected 19 years of data from 1976-1994 and actively managed funds returned on average .6% less than index funds.

Otter: There you see. If you compound this difference over 40 years you get 35%. index funds underperformed by 35%.

Snoop: Yo Otter, if the very large 12% difference in favor of managed funds based on one year wasn't representative for the population, why do you think this tiny .6% figure in favor of index funds is based on 19 years?

Otter: OK, statistics. It might be a small figure but way more precise when estimated on 19 years worth of data instead of only one.

Snoop: Luckily statistics can estimate the precision for us also. Based on my longer 1962-2000 sample for all funds I computed the standard deviation of the difference in log returns between the market and managed funds for a 19 year sample to be 1.3%. Compare that to the 0.6% average return difference (.58% in log terms) and with a t-statistic of .58/1.3=0.45 we find that the outperformance is located at the 67th percentile in the distribution of outcomes that should occur if there really is no population difference in returns between index and managed funds. There's not a single person in this world with an understanding of statistics that will tell you that this isn't in accordance with the hypostesis that X=0. To get significant outperformance you typically need the t-statistic to be located at the 95th percentile or higher. For this to happen the sample difference between index and managed fund returns would have needed to be at least 1.7% per year. Also, suppose we wanted to test if X=-.6%. The t-test for this hypothesis is at the 81st percentile and this not inconsistent with the data. In other words, if you can say that index funds outperform managed funds by .6% per year based on Wermers sample, I can say that index funds underperform by .6% in the population based on the same evidence.

Otter: But the difference really was .6%!

Snoop: Yes but that's a sample difference and we're interested in the population. The return difference will be different in different samples and you might easily have gotten -.6%.

Otter: Look Mr. I also flipped a coin 19 times and got tail 48% of the times. Thus I have an unfair coin.

Snoop: No Otter that's just a sample. I bet the population odds are 50%.

Otter: No it really was 48%. I wrote down the results of all 19 tosses, see?

Snoop: No, no, no. No! try tossing another 19 times and you'll see.

Otter: I did and got 52%. You are right the sample mean can differ from the population. Hmmm.

Snoop: Yes and likewise for the average difference in return between index and managed funds.

Otter: So what you are saying is that it's not inconsistent with the data to say that a possible outcome over the 19 years following Wermers period is the reverse, namely that managed funds will outperform index funds by .6%.

Snoop: Yes and everyone will agree with this. So yes, we agree that there was an average sample underperformance, but obviously are only interested in the population for which we haven't learned that there's underperformance.

Which study does one listen to? Which one do you believe? Wermers? Fama's?

What are you talking about? There's no disagreement!

Because an annual 65 bp IS meaningful in the real world, even if it is not statistically so,

Of course it's meaningful. If you and I toss a coin for $1 million and you win it's also meaningful (for both of us). However, the figure isn't high enough to say anything meaningful about the population difference in returns between managed and index funds.

I'm sorry Otter but your comments are not unlike what I've gotten from your colleagues on this matter. They are not unlike the comments I got when criticizing the Foolish Four a couple of years ago where people were laughing all the way to bank that ten percentage point or more average historical outperformance which was meaningful to them in the same way the .6% figure in meaningful to you. Boy did they learn from TMF's research study the difference between sample and population average.

*** Now if X varies over time in the population all bets are off. The historical evidence including the .6% average figure isn't informative at all unless we know how it varies.

Datasnooper.
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TMFOtter wrote:

If we're talking about a taxable account, well, given the fact that VFINX has only had a taxable distribution once in its history, I submit that the tax implications will not appreciably help the case for active management.

Just to clarify, I assume you mean capital gains distributions. The fund pays regular quarterly dividend distributions, which are certainly taxable.

Zarley

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dataznooper:
Snoop: Luckily statistics can estimate the precision for us also. Based on my longer 1962-2000 sample for all funds I computed the standard deviation of the difference in log returns between the market and managed funds for a 19 year sample to be 1.3%. Compare that to the 0.6% average return difference (.58% in log terms) and with a t-statistic of .58/1.3=0.45 we find that the outperformance is located at the 67th percentile in the distribution of outcomes that should occur if there really is no population difference in returns between index and managed funds. There's not a single person in this world with an understanding of statistics that will tell you that this isn't in accordance with the hypostesis that X=0.


Well, if you phrase it that it sounds awfully convincing, but something bothers me about this analysis, and maybe some statistician can answer me.

Ok, the calculation of standard deviation in the 19 year sample is 1.3%. Therefore, in any year the market and managed funds differed by an average of 130 basis points. But wouldn't the expectation of the differences in return over the entire 19 years therefore be tightened by the SQR of 19, roughly 4.4X, making 0.6% a couple of standard deviations out... I think that's about the 90th percentile. Still maybe not conclusive proof of underperformance by your definition, dataznooper.

I'm happy you started using numbers, though. :)
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duckdaring:

Ok, the calculation of standard deviation in the 19 year sample is 1.3%. Therefore, in any year the market and managed funds differed by an average of 130 basis points.

I don't think so. Snoop said:

Based on my longer 1962-2000 sample for all funds I computed the standard deviation of the difference in log returns between the market and managed funds for a 19 year sample to be 1.3%.

So, I believe the 1.3% is the s.d. for the entire 19 yr. period caluclated from 38 years of data.
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wouldn't the expectation of the differences in return over the entire 19 years therefore be tightened by the SQR of 19, roughly 4.4X, making 0.6% a couple of standard deviations out... I think that's about the 90th percentile.

I computed the standard deviation of the 19-year average differential return and thus already divided the annual standard deviation by sqrt(19). The 1.3% figure I gave is therefore correct.

Datasnooper.
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So, I believe the 1.3% is the s.d. for the entire 19 yr. period caluclated from 38 years of data.

Yes you're right. I took the annual standard deviation from 39 years of data and divided by sqrt(19).

Datasnooper.
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I should know better than to ever, ever try to follow up Snoop. Just two quick points:

I have the returns from the S&P 500 from 1966 to 2000. Let's use these average numbers on real data and extrapolate what a .6% underperformance per year is worth over the long term.

Apart from Snoop's excellent analysis, I have to highlight one other key finding of the Wermers study: the average managed fund performed exactly the same as the Vanguard 500 fund for the entire time period over which data were available. Not slight underperformance - matched raw performance, net of costs and fees. There is no evidence to suggest that an investor would have had any better raw performance going with the index fund than a managed fund. As always, there are risk and tax consequences, but TMF has been pretty consistent in its assertion that managed funds are serious underperformers before considering risk and tax issues. So you shouldn't have picked the S&P 500 as your market index, because we already know that during the study period there was no relative underperformance between the index fund and the average managed fund. A broad market index is another story.


Again, I'm not sure how the message ended up with "manage your own portfolio and kick the crap out of the professionals!", because I don't think that's an accurate depiction. I do think that on a net-net return basis pointing investors to an index fund is extremely sound and tax-efficient advice.

You never said "kick the crap out of the professionals," and I never claimed that you did. TMF has a fairly strong view of mutual funds, though. Of the three investment vehicles (index fund, managed fund, self-managed stock portfolio), TMF clearly ranks them:

1) Index fund
2) Self-managed portfolio
3) Managed fund

If you look at the mutual funds section of the Fool School, the Grand Overview of Mutual Funds playfully reads as follows:

Buy an index fund.

...with all the rest of the analysis organized as "Details" to that one principle. Quote: "Almost everything that you will ever read about mutual funds beyond "Buy an index fund" is superfluous to your long-term success in investing in mutual funds." See - http://www.fool.com/school/mutualfunds/basics/intro.htm . In other words, both the index fund and the self-managed portfolio are considered superior options to the managed funds - and it isn't even close.

Again, the Wermers study found that managed funds, on average, matched the performance of the most popular S&P 500 fund. Moreover, the Wermers study found that returns varied with turnover, such that the most actively traded mutual funds actually outperformed the market index (not the VFINX - the S&P 500 index itself). Both of those findings suggest that TMF's position on the relative merits of these strategies shouldn't be as strong as it has been at times.

Albaby
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I'm not sure if you mentioned GE just as a potential idea, or you actually own it. If you own it, I'd take a good long look at it. I think it is where KO was 5 years ago. At
best, you are looking at flat performance, and at worst negative returns over that time frame. First off, a large portion of GE's profits comes from its finance division, and I
have a feeling there could be problems there in the near future. More importantly, take a look at its total return over the past 5 years. How much of that was dividends and
earnings growth, and how much was multiple expansion? The vast majority was multiple expansion. That isn't a sustainable source of returns. Multiples tend to revert to
their mean values. Look at 20 years of GE P/E multiples, and compare the current multiple to that range. Furthermore, given GE's enormous market cap and revenues, how
realistic is it for GE to grow revenenues and earnings at 15% annually? How much more cost cutting can they do? I could be wrong, but at the moment GE looks like a bad
bet.

<><><>

I do own it and sustainable growth of GE capital is one of my concerns. I also agree that one can only grow so much by cost cutting. If GE can grow revenues at 15% annually going forward it is a steal at current prices. Thats a big if and one I'm wrestling with right now.

Mark
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No. of Recommendations: 35
Nice demagoguery, snoop. No really, I mean it, well done.

My griping about an unfair quarter was my favorite part. A stroke of genius.

My turn for a made up conversation:

NFL Ref: Chains!

Commentator: Looks like the Chiefs got a favorable spot on the ball, but this is going to be close.

Dennis Miller: Sort of like Jean Paul Marat's decision to take a cold bath.

Commentator: Shut up, Dennis. Here comes the measurement. They've made it just by the nose of the football!!

Ref: First Down, Chiefs!

Datasnooper: Wait just a minute, that measurement wasn't valid.

Ref: Who the hell are you?

Commentator: Who the hell is that?

Datasnooper: If my calculations are correct (and my calculations are always correct) The distance by which the ball made it past the first down marker was only 1.3 inches, which falls in the 33rd percentile of the distribution of outcomes for measurements that are, in fact, set by human hand and thus controvertible.

Ref: Huh? It's a first down. The Ball passed the marker! Get off the field, math boy!

Datasnooper: First you must tell me that the original 10 yards were accurately measured and not eyeballed. Since you did not line up the markers with the ball using GPS and vectoring, then we can assume that there is no way to really be able to tell within a 2.7 inch margin (I'm right about this) whether or not the chains were placed in true relation to the ball. Moreover, you have run through a three play sample, each time the ball was moved and replaced. Never once was the ball placed in the exact same position, so each play added an error rate that you can neither calculate nor adjust for. So for each play run you are using but a sample, not a population that completely accurately shows the exact level of performance by the team in its quest to advance the ball. Therefore after three plays any distance within 1.7 yards of the first down marker must be ruled inconclusive.

Dennis Miller: The funny thing about this is...

Datasnooper: Shut up, Dennis.

Ref: So it's impossible to tell whether or not the team actually got a first down.

Datasnooper: No, not impossible. If a player scores a touchdown, you can assume that he has also made a first down. Of course, you would have to know that the original placement of the ball was fraught with errors and 99% of the player's ability to advance the ball into the endzone was based on the luck of him happening to run where the defense wasn't. Your entire system of measurement does not hold enough precision, and therefore the entire game is invalid.

Ref: OK, well I have an idea. If a team gets within 1.7 yards of a first down, we can have a coin flip. I have this really cool coin we can use.

Datasnooper: yeah, funny thing about coin flips....

Chiefs Coach: Hey, ref! What the hell? We playing ball here or what?

Ref: Seeing as the attempt to measure progress is futile, I guess the entire foundation upon which football is built is invalid. Nah, Coach. Just go home. I'll call the NFL and get them to send you your last check.

----------------------

What you are saying is that without the full population, any amount of information you are using is sampling, and thus only tells you about the sample. Well we don't have data going back to the 1400's, nor do we have data from the future, so we cannot have a population.

Because even if we HAD every bit of the data from the past, every statement for every shmoe who has ever owned a mutual fund or an index fund we wouldn't have future data and thus we could make no determination of historic superiority?

Wow, what a racket.

Let's see where else we can apply this logic:

Datasnooper: Hello, Merrill Lynch? Yeah, I've had an account with you for 35 years and my overall performance has only trailed the S&P 500 by .7% per year. That falls below the threshhold for meaningfulness, so we have to assume that X=0. I need you to send me a check for $127,324.73.

Datasnooper: Yeah, Olympic committee? you're going to need to make the gold medal platform in speedskating a little wider. You see, the gold medalist only won by .014 seconds, which is statisically meaningless in this sample. You actually have 11 statistical winners.

Datasnooper: Hey, Osama? This is datasnooper. I wanted to talk to you about that 73 virgins in heaven for martyrs thing. Yeah, you're wrong to assume that each martyr receives 73, in fact within this sample it would be valid to say that a martyr would receive negative 73 three virgins. What's a negative virgin you ask? I don't know. I'm a statistician, that's real world stuff.

---------------

None of this comes close to addressing one of the suppositions of indexing over active management, that being tax efficiency. Particularly for the high turnover funds, we may be talking about inches where the true outperformance net of all fees, expenses and taxes to the end user changes the equation quite drastically.

That's it. My head hurts.
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Nice demagoguery, snoop. No really, I mean it, well done.

Otter, let me be direct here. You are the demagogue in this debate. Either that or you don't understand Datasnooper's point.

Your football example is specious. Everyone knows that first down measurements are, in fact, inaccurate to within several inches. That's why the over-riding rule in football and in all other sports is that the referee's word is final even if a billion people know he made a mistake. (Yeah, and then there's that instant replay junk, but the ref still has the final word.)

In this debate there is no room for referees' edicts, and you are not the referee anyhow. So please address Datasnooper's point, which is very real. You may claim that over a period of N particular years managed mutual funds trailed the index. But you cannot conclude with any reasonable confidence that it is a prevailing difference.

In other words, you have no basis for extrapolating from the statement:
"From 19xx to 20xx the average performance of managed mutual funds trailed the market index."
to the statement:
"The average performance of managed mutual funds trails the market index."

Elan
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I think we've beaten the horse to death several times over guys. It seems that there is little evidence that the average actively managed fund is any better or worse than the average index fund. (based on the studies and statistics presented in this thread) The problem with averages is that there is a population of underperformers and overperformers. The REAL challenge for the individual investor who decides to buy shares of an actively managed fund is to actually find the one that will peform above average. Since we have little to go by other than past performance we might as well settle for average, buy shares in an index fund and focus on our day jobs until we retire.

Maybe we should return our discussion to appropriate valuation strategies for high quality dominant companies.

Mark
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No. of Recommendations: 8
On the football part to be honest with you I haven't got a single clue about what football is about. I've never watched a game or even part of one. I used to know something called football but some genius has renamed it "soccer".

What you are saying is that without the full population, any amount of information you are using is sampling, and thus only tells you about the sample.

Yes and no. A sample obviously tells you about the sample but not only. If a sample told you about only the sample it would be totally irrelevant to compare historical performance of managed funds to index funds. You wouldn't learn a thing because any pattern would apply only to the sample. You and TMF use historical evidence to warn investors about managed funds and thus by definition you think historical evidence has predictive ability about the future. Equivalently you think a historical sample allows us to learn about not only the sample but also the population. I perfectly agree and the discipline of learning about the population from samples is canned statistics. I've illustrateed how from statistics based on the available historical sample there isn't sufficient evidence to distinguish between the population return on index and managed funds. Thus whenever you say that managed funds underperform index funds (speaking about the population) it's a pre-conceived opinion that relies on no factual evidence, because again no factual evidence exists to support the notion. My example of you tosing a coin 19 times is a precise illustration of the issue at hand so let me repeat it:

Otter: Look Mr. I also flipped a coin 19 times and got tail 48% of the times. Thus I have an unfair coin.

Snoop: No Otter that's just a sample. I bet the population odds are 50%.

Otter: No it really was 48%. I wrote down the results of all 19 tosses, see?

Snoop: No, no, no. No! try tossing another 19 times and you'll see.

Otter: I did and got 52%. You are right the sample mean can differ from the population. Hmmm.

Now obviously I can't say with certainty that you don't have an unfair coin, only that a sample of 19 tosses provide insufficient evidence to conclude that it's unfair in population. Try tossing 100,000 times and if odds are still 48% you can make your case. Likewise I can't say with certainty that managed funds don't underperform index funds in the population.

None of this comes close to addressing one of the suppositions of indexing over active management, that being tax efficiency. Particularly for the high turnover funds, we may be talking about inches where the true outperformance net of all fees, expenses and taxes to the end user changes the equation quite drastically

Fine but TMF's figures for fund performance never accounted for taxes and those are what we are discussing. Personally I argree with you and wouldn't invest in mutual funds in a taxable account and this includes index funds (Would use ETF's instead). In a tax-deferred account taxes are irrelevant. I've seen figures suggesting that 61 percent of stock fund investments that are individually owned (your targeted audience) are invested in tax-deferred accounts. You are talking past the majority here.

Datasnooper.
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I wrote: the discipline of learning about the population from samples is canned statistics

well some prefer it canned but I meant called. Sorry about that I'll get right some otter day.

Datasnooper.

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I wrote: Sorry about that I'll get right some otter day

I give up. Goodnight!

Datasnooper.
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"Get off the field, math boy!"

I love that.

Anywho, I have a quick question. I am not up to date on either study we are debating. But when you say the average managed fund, are you talking about every mutual fund out there, averaged together?

And as far as an indexed fund, are we talking about all of the indexed funds averaged together, or just the S&P 500 or what?

The answer to these question may help me contribute a significant point.

Thanks,

Samhain
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I've seen figures suggesting that 61 percent of stock fund investments that are individually owned (your targeted audience) are invested in tax-deferred accounts.

Snoop, I'd appreciate a link. My personal experience is just the opposite; nearly 2/3 of my "savings" are in taxable accounts. That's not for want of trying; when I was working I always put the maximum in the 401(k), opened IRAs, or used other tax-deferred vehicles (my wifes profit-share plan, etc.)

What role do retirement plan investments play in the mutual fund industry?
Mutual fund assets held in retirement accounts stood at $2.408 trillion at the end of 2000—or 35 percent of overall mutual fund assets. Mutual fund assets in 401(k) plans accounted for $766 billion, or 11 percent, of total mutual fund assets.


http://www.ici.org/retirement/401k_faqs.html

This jibes with reality, at least in my mind, because a) most of the wealth of the country is in the hands of the older population, and b) 401(k)s are only 20 years old. I'm 55. I would be surprised to find that my parents (both still alive) have any money at all in "tax-free" accounts.
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samhain:
Anywho, I have a quick question. I am not up to date on either study we are debating. But when you say the average managed fund, are you talking about every mutual fund out there, averaged together?

And as far as an indexed fund, are we talking about all of the indexed funds averaged together, or just the S&P 500 or what?


Not absolutely sure, either, though I think we're looking at the Wermers study that albaby1 introduced:

http://www.rhsmith.umd.edu/finance/rwermers/mutuals.pdf

In that one, the average managed fund is created by looking at all domestic funds that label themselves things like value, growth, or mixed, but are not tied to a particular sector. The index fund used is the Vanguard Index 500 fund.

I'd still like to see what actual data was used, but as it is, I'd have to commend dataznooper for showing that the two fund categories are essentially tied here.

Now the ugly part:

If the Rule Maker portfolio lasts for twenty years and outperforms the S&P 500's CAGR by a whole 100 basis points, we will have to conclude the thing was a waste of time. We should have bought an index fund and taken up collecting bottle caps.

:)
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In that one, the average managed fund is created by looking at all domestic funds that label themselves things like value, growth, or mixed, but are not tied to a particular sector. The index fund used is the Vanguard Index 500 fund.

If this is true, then I would much rather purchase the Vanguard Index 500 for reasons 2.

1 - If I am unlucky or do not do my homework, then I may put my money in the funds that underperfomed the Vanguard Index. It is true that I may also be lucky and put my money in a fund that outperforms the market - but if I'm looking to beat the S&P 500, then why am I looking at these kind of funds in the first place?

2 - If I wanted to acheive the average return for all domestic funds (as stated above) then I would have to put my money in a lot of different funds. Isn't it easier and much much cheaper to put my money in one fund (the Vanguard 500) that I know is diverisified, rather than put my money in hundreds of other funds. This diversification scheme makes no sense.

I must be missing something because this seems clear cut to me.

Samhain
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On the football part to be honest with you I haven't got a single clue about what football is about. I've never watched a game or even part of one. I used to know something called football but some genius has renamed it "soccer".

I watch football but I have never understood the ins and outs of the rules. Good grief, look at the number of officials. I think there are six on the field, four to work the chains (three on one side, one on the other), scorekeepers, timers. I figure 14 for 22 players.

Basketball has 6 or 7 for 10 players.

Soccer has 3 for 22 players.

Rule Maker investing has 13,564 referees for 4 or 5 players.

Randall
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Snoop:

My example of you tosing a coin 19 times is a precise illustration of the issue at hand so let me repeat it:
Otter: Look Mr. I also flipped a coin 19 times and got tail 48% of the times.



That is a great analogy, however 48% of 19 is 9.12 flips. So, while I agree it is a precise illustration, it certainly doesn't use precise math.
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If this is true, then I would much rather purchase the Vanguard Index 500 for reasons 2.

1 - If I am unlucky or do not do my homework, then I may put my money in the funds that underperfomed the Vanguard Index. It
is true that I may also be lucky and put my money in a fund that outperforms the market - but if I'm looking to beat the S&P 500,
then why am I looking at these kind of funds in the first place?

2 - If I wanted to acheive the average return for all domestic funds (as stated above) then I would have to put my money in a lot of
different funds. Isn't it easier and much much cheaper to put my money in one fund (the Vanguard 500) that I know is diverisified,
rather than put my money in hundreds of other funds. This diversification scheme makes no sense.

I must be missing something because this seems clear cut to me.


I think everyone here would make the same choice. The debate is whether we'd make it because index funds are safer and easier or because, as TMF claims, managed funds have an expectation of lower returns than index funds.

Elan
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GoofyHoofy quotes: Mutual fund assets held in retirement accounts stood at $2.408 trillion at the end of 2000—or 35 percent of overall mutual fund assets.

My information covered all tax-deferred accounts including retirement accounts but your figure of roughly one-third actually corresponds to the information I have because retirement accounts make up the majority of tax-deferred money:

Most stock fund assets owned by individuals are held in tax-deferred retirement accounts, such as 401(k) plans and IRAs. At year-end 2000, 61 percent of all individually owned stock fund assets were invested in tax-deferred accounts. Moreover, approximately one of every three dollars in mutual funds is held in retirement plans and accounts.
http://www.ici.org/aboutfunds/stock_fund_faqs.html

As you can see my 61 percent figure represents only individually owned stock fund assets, which is the relevant figure for the purpose of the Fool's advice. The one-third figure that you also have relates to all mutual fund assets (also non-stock funds) and also includes holdings that aren't individually owned.

Datasnooper.
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No. of Recommendations: 8
Hey, quite a bit of excitement on this thread. I saw a post or two up on the "Best of the boards" and guess thought I would look in. Yep, Cash Phlo posted the identical thing over on the index fund board, but the coversation didn't go much of anywhere.

But, it brought to mind a couple of conversations that I took part in about six months ago. I posted this as a joke:

http://boards.fool.com/Message.asp?mid=15390067&sort=recommendations

I posted it because always someone is coming up with data that over some given time period some percentage of mutual funds is outperforming index funds and index funds are on the way out.

So, datasnooper kindly posted this list of funds that had really beaten the index over 30 years.

http://boards.fool.com/Message.asp?mid=15401049

My main point in that discussion was that even knowing that some funds beat the index, there is NO WAY to predict which funds will continue to beat the index. And the longer you index, the more likely you are to beat the majority of mutual funds, up to 80% or more the longer the time period.

http://boards.fool.com/Message.asp?mid=15401314

datasnooper responded that he thinks that an index fund maybe beats 60% of mutual funds over time
http://boards.fool.com/Message.asp?mid=15403804

I responded by looking at the list of 62 mutual funds that had "beaten" the index over the 30 year time period, showing that loads, and taxes do provide a significant drag on mutual fund returns over time, but since it is not necessary to report it, it is generally ignored. After accounting for taxes and loads, only 7 of 256 funds beat the index, or 2.7% of mutual funds in existence in the measured time period.

http://boards.fool.com/Message.asp?mid=15416387

And so, even if you do not believe the facts, you have to recognize that loads and taxes provide a major drag, especially for those that DCA into mutual funds outside of tax advantaged savings plans such as IRAs. The effects of a load are especially magnified over shorter time periods.

All things considered, I have tried a number of different styles of investing and realize that by indexing, I have tilted the field in my favor simply because of the reduced expenses and reduced taxes . There is no really magic and there is no way to predict which mutual fund may outperform the index in the future nor which stocks as a group (think of it as your personal mutual fund) may outperform the major indexes over the long haul.

Best regards,

Gurupa




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One thought on the Wermer study... it actually shows that mutual funds underperform an index fund because of frictional costs.

http://www.rhsmith.umd.edu/finance/rwermers/mutuals.pdf

We find that funds hold stocks that outperform the market by 1.3 percent per year, but their net returns underperform by one percent. Of the 2.3 percent difference between these results, 0.7 percent is due to the underperformance of nonstock holdings, whereas 1.6 percent is due to expenses and transactions costs.... and underperformance is underperformance.

Also, there is no indication whether any out performance in stock picking over the index is because of increased risk taking. For example, if VFINX has a beta of 1.00 and Janus fund has a beta of 1.38, than it should beat the index by 38% over the given time period. I would be interesting to see someone put up a list of mutual funds here in this thread or a group of stocks (rule-makers or otherwise) that will beat the index on a risk adjusted basis after costs. Name your stocks or name your mutual funds and name your time period. The theories are nice, but show me the money. Because as one poster said, you may just all be better off investing in the index and collecting bottle caps.

Regards,

Gurupa
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After accounting for taxes and loads, only 7 of 256 funds beat the index, or 2.7% of mutual funds in existence in the measured time period.

I don't agree with your analysis. Taxes are difficult to tackle and they don't matter in tax-deferred accounts. You would only buy a load fund when planning to hold it for a long time and then the importance of the load is minor. Finally, when comparing to index funds even the Vanguard S&P 500 started out charging a load. Thus loads 30 years ago would not change the relative attractiveness of managed funds to index funds (although index funds came into existence a few years later).

Datasnooper.
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Albaby wrote: I have to highlight one other key finding of the Wermers study: the average managed fund performed exactly the same as the Vanguard 500 fund for the entire time period over which data were available. Not slight underperformance - matched raw performance, net of costs and fees. There is no evidence to suggest that an investor would have had any better raw performance going with the index fund than a managed fund.

This is an important point that I haven't previously given much attention. Furthermore in a 1996 Journal of Finance paper by Martin Gruber of NYU he writes that in the beginning of 1985 there were just three S&P 500 index funds available with average expense ratio of 1.24 percent per year. Needless to say such an expense ratio wipes out any performance advantage index funds may have gross of expenses.

Datasnooper.
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An intheresting conversation is taking place here, althow not really focused on Rule Maker strategies. Any way, I guess I'll just add up one more!

I haven't read all the 60 plus post here, but so far, I haven't seen any concern about the performance of the "People", investing in mutual founds. I heard that most founds investors are continually jumping from one found to the other, in attempt to pick up the most performing ones. Doing so, they sell their loosers to reinvest in founds that have shown a good short term performance. And since these good performances do not necessarely repeat in the following year, they loose again!

It turns out that the performance of the mutual found "investor" is averaging a poor performance, much lower than the average found performance. Are there statistics showing this ?? And if this is true, isn't this another argument in favor of index founds ??

Pierre
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I haven't seen any concern about the performance of the "People", investing in mutual founds. I heard that most founds
investors are continually jumping from one found to the other, in attempt to pick up the most performing ones. Doing so, they sell their loosers to reinvest in founds that have
shown a good short term performance. And since these good performances do not necessarely repeat in the following year, they loose again!

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It seems logical that the most important thing about mutual fund investing would be selecting quality funds (whether actively managed or indexed) with a low expense ratio and parking your $$ for a long time. The point you raise about the folly of chasing last years hot funds is far more important than the statistically insignificant differnces between index funds and the average actively managed fund. IMHO the more actively the amateur trades the more likely he or she is to make a mistake and underperform.

scm
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