2 Index Fund Studies Remind Us Of 1 Good Strategy

by: Rick Ferri

Index fund investors let the facts speak for themselves. The long-term data comparing active funds to index funds shows actively managed mutual funds underperform in all asset classes and all investment styles. There is no ambiguity in the results, and there's nothing new to report here. The data has been saying the same thing for decades.

But, we're only human. We forget, and lies are constantly being told that cause us to second-guess our resolve. It's a good idea to revisit the data at least once a year just to remind ourselves why we believe what we believe: that we should continue to invest in index funds rather than active management.

I recommend two studies published annually to keep index fund investors on the straight and narrow. They are Vanguard's The case for index-fund investing and S&P Dow Jones Indices' year-end SPIVA® U.S. Scorecard. Both reports have been recently updated through year-end 2014, and together they'll give you all the data needed to reconfirm that you're doing the right thing by investing in index funds.

Vanguard's Case

The case for index fund investing is a well-written, well-illustrated look at active versus passive investing, and it will only take about 30 minutes to read. Overall, it offers a detailed look at the theory behind indexing and includes comprehensive supporting data.

The general theory is that performance is directly related to managing costs. Portfolio management is a zero-sum game. There is only a finite amount of money that can be earned in the markets each year. When one active investor extracts more than his or her fair share, it means another one earns less and this is before costs. Since no one invests for free, investment cost ultimately causes most active funds to underperform the markets in the long term.

Vanguard captures comparative return data across a range of global equity and fixed income styles. Its report explores the effect of survivorship bias in mutual fund reporting, why volatility is higher in active funds, and the lack of persistence among past winning styles and winning active funds.

S&P Dow Jones Has The Score

The S&P Dow Jones SPIVA® U.S. Scorecard is published semiannually at mid-year and year-end. This report is a number cruncher's dream. SPIVA provides 20 pages of raw data you can analyze top down, bottom up, sideways, and nearly any other way you desire to glean truths from it.

SPIVA divides the data into multiple tables covering different time periods, equal-weighted returns and asset-weighted returns. There's information on survivorship bias in every asset class and style, and data on the style consistency of fund managers. The year-end 2014 report has data going back 10 years.

Power In Numbers

The two reports obtain their mutual fund data from different places that separate funds into styles using different methods. Plus, the two use different benchmarks to compare active versus passive performance. Vanguard categorizes large-cap blend managers using Morningstar data and compares the results to the benchmarks in the fund prospectuses. SPIVA uses Center for Research in Security Prices' (NASDAQ:CRSP) mutual fund category data, and compares performance to the S&P 500 Index. Their results don't align perfectly, but they're close. The similarity strengthens the conclusion. Figure 1 provides examples:

Figure 1: Percentage of active managers underperforming over 5 years ending 2014

Source: Vanguard The case for index fund investing (March 2015, page 11, Figure 8), S&P Dow Jones SPIVA® U.S. Scorecard (Year-End 2014, page 4, Report 1)

Long-term, actively managed mutual funds underperform the indexes they're trying to beat. This occurs across the board in all asset classes and styles. There's nothing new about this. Some time ago, I documented this in my book, The Power of Passive Investing. Fortunately, more people are listening and benefiting from index investing. These two reports published by Vanguard and SPIVA are great reminders to continue heeding the advice.

Disclosure: Author's positions can be viewed here.