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HomeMy WebLinkAboutHandouts_Pension Public Safety_Handout No.2_11/02/2009When Index Funds Really Shine - WSJ.com http://online.wsj.com/article/SB 100014240527487041072045744735... ~~ ~ ~NI) lRE FI[VL]11VG. ~w~.sr~er~ ~ SATE Dow.bnes Reprints: This copy is for your personal, non-commercial use onty. To order presentation-ready copies for distribution to your colleagues, Gients or customers, use the Order Reprints tool at the bottom of any article or visit www.djreprints.com See a sample reprint in PDF format. Order a reprint of this article now 1~1 117IJ ~2fLl~ ~ t,~V~r. 1MS! cxera NOVEMBER 2, 2009 FUNDAMENTALS OFINVESIING When Indexing Really Shines Anew study challenges the widespread belief that index funds are most useful with large stocks. Instead, they're most likely to beat managed funds in whatever stock category is hot. By KAREN RUBE In the long-running debate about whether to favor index mutual funds or actively managed funds, many investors agree on one thing: Index funds are best for large stocks, while active management has an edge in smaller stocks. The idea is that the market for large stocks is highly efficient-that is, just about all the available information that could affect the market is quickly reflected in prices, making it hard for a fund manager to fmd the edge needed to outperform the sector. In the market for smaller stocks, the thinking goes, less information is widely known, enabling a stock picker to uncover overlooked gems. This idea pops up frequently in conversation with financial planners and is the basis of common advice about how to invest in mutual funds. The problem is, this conventional wisdom has been largely debunked, and investors who abide by it could be hurting their returns over time. Anew study that looked at fund performance in the decade through 200 found that market efficiency wasn't a useful gauge in choosing between index and active funds for different types of U.S.-stock exposure. Over that period, a higher percentage of actively managed large-stock funds beat their respective indexes than of active small-stock funds. The study, by wlliam Thatcher, a financial adviser at research and consulting firm Hammond Associates in St. Louis, found that performance follows a different pattern: Indexing tends to beat active management in top-performing asset classes-no matter how efficient they are-and it loses to active management in the worst- performing asset classes. Mr. Thatcher's study confirmed a relationship reported about io years ago by two other fuiancial advisers. In the io years through 200, the S&P MidCap 40o was one of the top-performing indexes, with an 11.2 annualized return. That index beat ~8 % of actively managed funds in research firm Morningstar Inc.'s midcap-blend category, Mr. Thatcher says. One of the lowest-performing indexes during that period was the large-stock S&P Soo/Citigroup Growth measure, with a 4.8 % average annual return. That index was beaten by 65% of active managers, he says. If you look at a long list of Standard & Poor's, Russell and MSCI indexes, there is a consistent pattern over the decade of Mr. Thatcher's study: As performance declines, the percentage of active managers trailing the indexes also declines. 1 of 3 ~~~0 r,Jr ~ ~'/ ,. ~ ~ ~ ~~ ©~ 11/2/2009 10:52 AM When Index Funds Really Shine - WSJ.com http://online.wsj.com/article/SB100014240527487041072045744735... The Purity Factor One reason index funds shine intop-performing areas of the market, Mr. Thatcher says, is that they participate fully in the upswing, while active managers hold only a fraction of an index and maybe missing out on the strongest stocks. He adds that another reason for his findings is that many active managers don t stay true to a particular style. A midcap manager may stray out of the midcap arena and hold some large and some small stocks. If the midcap index outperforms others, the manager wouldn't capture its upswing entirely. If the index performs worse than others, the active manager's portfolio would be buoyed by stocks that are outside its style. "In the best-performing asset classes, index funds are rewarded for their purity and active managers are punished for their impurity," Mr. Thatcher says. "The bottom line is that the more style-pure a fund is, the better it performs when its style does well, and the worse it performs when its style does poorly." The idea that investors should hold index funds according to market efficiency became a truism in the early i99os, when an analyst at Morningstar published a paper about it. Between 1992 and 1998, the theory appeared to be borne out as the S&P 50o beat 95% of large-blend mutual funds, and the small-cap S&P 60o and MSCI Emerging Markets Index trailed average returns for comparable actively managed funds. The theory doesn't hold, however, in the decade studied by Mr. Thatcher, during which most large-cap indexes were beaten by more than half of active managers, and most small-cap indexes beat more than half of actively managed funds. Research in 1999 by financial advisers Steve Dunn and wlliam Bernstein debunked the efficiency theory and pointed instead to the fact that indexing typically does best in strong-performing asset classes. Indeed, in the 1992-98 Period when the S&P 50o was so tough for active managers to beat, the largest stocks were market leaders in the U.S. Yet many investors and advisers never let goof the idea that decisions should be based on market efficiency, because it makes intuitive sense. This prompted Mr. Thatcher to put the so-called Dunn s Law to the test over a more recent period. The theory hasn't been fully tested yet across other markets, such as bonds and emerging markets, which Mr. Thatcher didn't study. But in the first half of this year, as it relates to U.S. stocks, Dunn's Law appears to be holding up. According to Morningstar, in the first half of the year, when growth indexes had the highest returns, the percentage of actively managed growth funds that beat their Morningstar style index was low. Meanwhile, value indexes had the lowest returns, and the percentage of active managers beating their style indexes was high. From Study to Strategy So how can an investor benefit from Mr. Thatcher's findings? They indicate the best returns can be scored by favoring index funds in stock-market segments you believe will be the strongest and choosing actively managed funds for those that will have the weakest performance. One limitation: Mr. Thatcher found that the relationship between relative performance and the benefits of indexing didn't play out as consistently over one-year periods as over the decade he studied. Also, to play that game, you have to be able to predict what asset classes will be the best. "No one can do that consistently," says Mr. Bernstein, co-founder of Efficient Frontier Advisors LLC in Eastford, Conn. Mr. Thatcher suggests that because market timing is impossible, investors should favor index funds in their portfolios with along-term tilt toward the market segments that appear poised for the strongest growth. Now, 2 of 3 11/2/2009 10:52 AM When Index Funds Really Shine - WSJ.com http://online.wsj.com/article/SB100014240527487041072045744735... that area appears to him to be large growth stocks, he says. "We're not prescient, we just look for huge undervaluation," Mr. Thatcher says. -Ms. Hube is a writer in Westport, Conn. She can be reached at reports@wsj.com. Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved This copy is for your personal, noncommercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please corrtact Dow Jones Reprirrts at 1-800-843-0008 or visit www.djreprints.com 3 of 3 11/2/2009 10:52 AM