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The data behind indexing

With any endeavor a person undertakes, there’s usually some future goal that is set before the activity commences. If that goal is to become a doctor, one must take an entrance exam to gain acceptance into medical school, complete a residency program, and pass their boards in order to become officially recognized as a board-certified physician. Likewise, when one decides to part with their hard-earned money today in exchange for future earnings, there must be a goal in mind as to the amount of future return one is willing to accept in lieu of having their money in hand to spend today.

That goal is always based on a return of an investor’s capital. Many money managers tasked with turning that hope into a reality measure their performance against a major benchmark index, like the S&P 500. The index consists of 500 of the largest companies based on market capitalization. The companies within the index account for about 80% of the entire market cap of the U.S. economy, making it a good indication of how the overall economy is doing.

The average annual total return of the S&P 500 index over the ten-year period ended in June, 2015, was 7.89%. Historically, this index has returned around 7%, with the reinvestment of dividends and after inflation. Every single money manager who actively attempts to outperform this index is competing with other active managers. But not everyone can produce above average returns, since they are trading with one another; therefore, there must be some winners and some losers among the group.

Playing the odds

There have always been fund managers who have outperformed, and there will always continue to be. The difficulty is identifying who they will be before they make their great runs. And even after a year or two of outperformance, history suggests that there are very few who can consistently outperform over the long term. Data suggest that the odds are even more in favor of passive investors when a portfolio consists of more than one fund. And since ample diversification should be a key component to every investing strategy, the probability of actively outperforming the market with multiple funds is even less likely. Figure 1 illustrates just how difficult it is to select mutual funds that attempt to outperform indices over an extended period of time.1

Figure 1. Active vs. index, 1997-2012

The study examined the returns of a basic portfolio comprised of three index funds and compared the results to 5,000 active mutual funds randomly selected from the same three categories as the all-index portfolio. The weightings of the three funds were equally allocated between the two sets of portfolios. Out of the 5,000 actively-managed funds, 4,144 did not beat the portfolio comprised of a total equity index fund, an international equity index fund, and a U.S. bond index fund. In other words, if an investor attempted to beat this basic portfolio of index funds, they would have lost 82.9% of the time. Moreover, underperforming active portfolios lost by a median of 1.25%; a significant loss when compared to the 17.1% that outperformed by a mere 0.52%. There will always be funds that outperform, the hard part is picking the right ones ahead of time, and doing it year after year.

A needle in a haystack

Investing is not supposed to be exciting. If excitement is desired, it's best to take a very limited amount of money and head to the casino. This is not to suggest that investing can't be exciting. It can be very exhilarating to watch your portfolio grow or take greater risks in single stocks, albeit with a limited percentage of your total portfolio, depending on the particular risk tolerance you may have at that point in time. It must be noted, however, that placing 10-15% of your capital on one stock is like trying to search for a needle in a haystack. The same can be said for trying to find that one money manager or investment advisor who promises to continue their excellent past performance of 8-10% per year. In either scenario, it's not that finding excellent stocks or high-performing money managers is impossible, it's that over extended periods of time, it's much less likely that single stocks or managers will be able to outperform a basic S&P 500 index fund.

One of the great investors of all time, John Bogle, said it best when he stated "don't look for the needle in the haystack. Just buy the haystack!" Fortunately, the costs of buying the haystack have never been lower, which translates into immediate returns for investors.

1. Notes: The index fund portfolio performance was subtracted from each randomly selected active portfolio performance to find the relative performance difference, or “active portfolio excess performance.” Sorting these performance differences from the worst (left) to best (right) helps visualize the distribution pattern of the outcomes. The X-axis in each of the 5,000 trials and the Y-axis is the annualized percentage return for each trial under or over the all index fund portfolio. There were 4,144 underperforming actively managed fund portfolios and 856 outperforming portfolios.

*Index fund portfolios were comprised of the following: Vanguard Total Stock Market Index Fund Investor Shares (VTSMX) 40%, Vanguard Total International Stock Index Fund Investor Shares (VGTSX) 20%, Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) 40%. Source: Ferri, Richard A. and Benke, Alex C. "A Case for Index Fund Portfolios," June 2013.

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