Index Returns Stride Far from Mediocre

I have always been an enthusiastic advocate oflow-cost, broad-based stock index funds. Ithink they're the greatest thing since broccoli.Actually, in some ways they're even better thanbroccoli. You can't live on broccoli alone, but youcan achieve a lifetime of investment success byinvesting solely in index funds.

So, I was a little excited to see anarticle in a recent issue of Forbes withheadlines implying that the magazinewas finally ready to enthusiasticallyadvocate index funds without adding alot of if's and but's about them. The articleis a step in the right direction, but islikely to still leave readers ambivalentabout the merits of index funds.

The article suffers from the same 2key problems that pervade most discussionsof index funds in the media. Iteffectively says index funds offer"guaranteed mediocrity" and alsomentions that only 1 in 3 actively managedfunds in operation since 1976 hasbeaten the Vanguard S&P 500 IndexFund. No one would want to invest ina guaranteed mediocrity. This is damningwith faint praise, if it's praise at all. It alsoleaves the reader with the impression that there'sa large number of actively managed funds outthere—constituting that one third that have andwill outperform index funds—and investorsshould continue to search for them.

Forbes

This is the tenor of most index fund coveragein the media. Let's not single out ; it couldhave been an article in any one of the major businessmagazines. Meanwhile, the financial serviceindustry paints an even less favorable picture ofindex funds. Let's examine why this is misleading.

OUTSTANDING AVERAGE

Stock market indexes like the S&P 500 representaverages of the stocks included in them.Broadly speaking, about 50% of actively managedfunds should outperform comparable indexfunds, and the other 50% should underperformthem. This is no different thansaying about 50% of the students in aclass will be taller than the averagestudent. Given that, the question youhave to ask right away is, why are onlya third of the funds outperforming theindex funds even though highly paidinvestment professionalsmanage them?

Well, most activelymanaged funds incurtotal investment costsof between 1.5% and3% per year for managementfees, brokeragecommissions, etc,compared to 0.25% to0.5% per year for good index funds.The difference may not sound likemuch, but over long periods of time, itmakes a huge difference.

Actively managed funds are running marathonswith a lot of extra weight on their backs, andtheir managers have to be true geniuses to overcomethat extra weight and do better than thelowly index funds, which turn in an average performanceyear after year. Unfortunately, truegeniuses in the field of investing are rare.

So even though index funds provide onlyaverage returns, in this case you should not feelashamed to shoot for the average. The fact thatthey outperform two thirds of actively managedfunds makes this an outstanding performance,not a mediocre one.

A MIRAGE REVEALED

If we accept the number Forbes cites, which islikely somewhat overstated, there are still a lot offunds—that superior one third—that do betterthan the index funds. Shouldn't you be looking forthem instead of settling for the average? Well, mostpeople fall for that.They think that even if they maynot be able to tell which one third will outperformthe index funds, there must be gurus who can.

Forbes

This is not the kind of thinking you shouldindulge in. Both the media and thefinancial services industry are eagerto be your gurus, at a high cost. Thatsame issue of enthusiasticallyrecommends a list of actively managedfunds it thinks will outperformthe index funds in the future.

The bad news is, there's hardlyany evidence to show that anyonecan reliably predict which onethird of the funds will outperform the indexfunds in the future, either in the short run or inthe long run.The winning group keeps changingfrom year to year. After the fact, there will alwaysbe some funds that outperform, just as there arewinners in lotteries. But if you can't tell ahead oftime which ones will outperform, it doesn't matterthat some eventually will.

Remember:

Life's a 1-way street. If you waste too manyyears in search of that elusive one third, you won'tbe able to go back and start all over again. Youwon't be able to make up for lost years. Next timeyou read an unflattering article on index funds,don't let it mislead you. In investing,average return is not mediocre; it's outstanding.

Chandan Sengupta,author of The Only Proven Road to InvestmentSuccess (John Wiley; 2001), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consultswith individuals on financial planning andinvestment management. He welcomesquestions or comments at chandansen@aol.com.