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Index Vs. Managed Funds
Do managed mutual funds outperform index funds? Not
necessarily, at least according to research I conducted last week.
The debate about the returns achieved by managed
funds vs. index funds has raged since Vanguard introduced the first
index fund in 1975. I’ll get into the details of what I learned in a
minute. But first some background.
Prior to 1975, all mutual funds were run by
managers who handpicked stocks they expected to outperform the market.
By contrast, index funds simply attempt to mimic the returns of a fixed
set of stocks. For instance, Vanguard’s first fund, the Vanguard 500,
emulates the performance of the S&P 500 index, which consists of 500 of
the largest U.S.-listed stocks.
The list of stocks making up the index is
relatively stable, changing only when one of them is acquired or is
tottering on the brink of bankruptcy.
Managed Funds Should Be a No-Brainer
Since an index fund must own all stocks making up the index, even
those in trouble; you’d expect that a managed fund could easily
outperform its index by simply avoiding the obvious dogs. But that
hasn’t necessarily happened.
The S&P 500 index is capitalization weighted,
meaning it is mostly influenced by the price action of its biggest
members. During the mid-1990s, the market’s strong results were driven
by large companies such as Microsoft and Coca Cola, and managed funds
struggled to keep up with the index.
However, the pendulum swung back in favor of
managed funds during the late 1990s when technology stocks, many of them
smaller companies, soared.
Curious
Last week, curious about the recent performance of actively
managed funds vs. index funds, I used Morningstar’s Premium Mutual Fund
Screener (www.morningstar.com)
to research the topic. The screener is part of Morningstar’s Premium
Membership package, which costs $14.95 per month or $135 per year.
However, you can try it free for 14 days, which would give you plenty of
time to check my findings.
First, I used the screener to list the index funds
tracking each of the following categories: small-cap growth, small-cap
value, large-cap growth and large-cap value. Let me explain these terms.
Market capitalization (shares outstanding
multiplied by the last stock price) is a measure of company size.
Definitions vary, but typically, stocks with market-caps below $1
billion are considered “small-cap” and those with market-caps above $10
billion are “large-caps.”
Growth stocks are stocks that the market views as
having strong sales and earnings growth prospects. Value stocks are
stocks trading at relatively low prices because they are out of favor
with most investors, typically because something has gone wrong.
Getting back to my list of categories; small-cap
value, for instance, means that a fund in that category holds mostly
small-cap, value-priced stocks.
Three- and Five-Year Returns
For each category, I separately averaged the three-year and then
the five-year returns of the index funds tracking stocks in the group.
For instance, the index funds tracking large-cap growth stocks returned
8%, on average, annually, over the past three
years, but only 1%, on average, annually, over
the last five years.
Then, I used Morningstar’s screener to report the
number of managed funds in each category that did, or did not, beat the
index funds returns over the same periods. For instance, I counted the
number of large-cap growth funds that averaged better or worse than
8% returns over the past three years.
Surprising Results
The results surprised me. Looking at the last three-years, except
for the large-growth category, most managed funds underperformed their
category's index funds. Here’s the percentage of managed funds that
outperformed their index over the past three years for each category:
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Small Growth: 34%
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Small Value: 39%
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Large Growth: 68%
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Large Value: 39%
Since 2002 was a particularly bad year for the
market (the S&P 500 lost 22%, looking at the
past five years returns gives you a better perspective as to how funds
performed in both weak and strong markets.
Over that timeframe, most managed value funds
outperformed their indexes, but managed growth funds didn’t fare as
well. Here’s the percentage of managed funds that outperformed their
category index over the past five years.
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Small Growth: 17%
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Small Value: 63%
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Large Growth: 45%
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Large Value: 73%
At first glance, you might conclude that, at least
for growth investors, managed funds are a bad idea. But I don’t think
that is necessarily so. For instance, again using Morningstar’s
screener, I found that 93 large-cap growth funds have consistently
beaten the S&P 500 index over each of the past three-, five-, and 10
year periods.
To me, the data warns that you can’t get by
randomly picking funds. You have to do your homework to pinpoint the
funds with the best prospects. My last column,“How
to Pick the Best Mutual Funds” covered
that topic and you can get even more information from Morningstar’s free
Investing Classroom (click on Learn near bottom of
Morningstar's home page).
published 7/9/06 |
