Saturday, October 28, 2006

Scorecard: Index v. Active

How are active managers doing compared to indexes this year? As cited in Sunday's New York Times article by Paul Lim, so far through September 30th of this year, only 28.5% of actively managed large cap mutual funds were beating the S&P 500 index according to a new study by Standard and Poors. When looking at the most recent quarter alone, only 20% beat the S&P 500.

One reason why the percentage has been low lately is that it tends to be more difficult to beat the index when market leadership changes. Energy and small cap stocks have been outperforming for years, but that changed lately and active managers haven't kept pace. However, it's not just over the short-term that the index has been outperforming actively managed funds, however. Over the last five years, only 29.1% of large-cap funds have managed to beat the S&P 500.

What I found a little surprising was that even a smaller percentage (19.5%) of actively managed small-cap funds managed to beat their benchmark, the S&P 600 (an index of small-cap stocks, not the S&P 500 plus the next 100 stocks). This goes against the argument that it's easier to outperform the market in small-caps due to less competition and less institutional research coverage of smaller cap stocks.

Getting back to large-cap stocks, Lim writes that even though the S&P 500 index surged in popularity in the late 90's (when mega-cap stocks like Microsoft and Cisco were driving impressive gains of more than 20% a year) indexing advocates like John Bogle (founder of Vanguard) point out that indexing is even more valuable when returns are more modest. During a period in which returns average 6-7% a year, for example, transaction fees, taxes, and investment management fees of actively managed funds will eat up a proportionately larger share of the returns.

Judging by the numbers, it's hard to make a case for actively managed funds either in the short or long term.

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