A couple of days ago the WSJ reported big news in the mutual fund world—active managers have outperformed index funds thus far in 2015. Which prompted me to update a little study I did three years ago that compared the 10-year performance of Fidelity Investment’s actively managed domestic equity funds with its index funds. Once again, the active managers failed to beat the index funds by enough to cover the higher taxes and higher risks associated with active management. One other important finding: Fido’s mid-cap funds tended to outperform large-cap funds.
I looked at 31 actively managed funds (24 large-cap and 7 mid-cap) and compared them with 3 index funds. Here are the results:
- The three index funds had an average annual return over the past decade of 8.62% (median 8.77%).
- The average performance of the 31 actively managed funds was a trivial 24 bps better than the index funds.
- The 24 large-cap funds underperformed the index funds by 35 bps.
- The 7 mid-cap funds outperformed the index funds by an impressive 104 bps (median 113 bps). This is consistent with what others have observed. Mid-cap stocks are the “sweet spot” in the equity universe. They are stronger than small-caps but unlike large-cap stocks they are not battling the “law of large numbers;” they are likely to be acquired by larger firms; and they may command a higher valuation (PE multiple) as they grow in size, became more liquid securities, and pick up Wall Street coverage.
- The risk in owning actively managed funds is substantial. Of the 31 funds, 6 (all of them large-cap funds) posted returns of less than 7%. These 6 funds posted an average of 5.92%, underperforming the index funds by a huge 270 bps.
- Large cap mutual funds generally don’t outperform index funds meaningfully—certainly not by enough to cover higher taxes and the risk you will buy a crappy fund that substantially underperforms.
- If you do buy index funds, don’t just stick to large-cap funds. Allocate some capital to a mid-cap index fund, such as a fund that equal-weights the stocks in the S&P 500. (Because the top 50 stocks in the S&P 500 account for half of its total market cap, it is effectively a large-cap index. However, if you equal-weight all 500 names, it becomes a mid-cap index.)
The Trouble with Index Funds . . .
. . . is that you will fully participate in the stock market mega-manias that develop over time—energy stocks in the late 1970s, tech stocks in the late 1990s, financial stocks in 2008. By 1999, for example, the S&P 500 had a huge 40% weighting of TMT (technology, media, telecom stocks) not only because these sectors had strong earnings and sky-high PE ratios, but also because the Standard & Poors Index Committee added tech stocks to the index once they became “important,” “representative” stocks – that is, after they had run up in price. This was disastrous for index fund investors, who got little of the upside but all of the downside on dozens of “high-flyers” that fell to earth. Hypothetical example: XYZ Inc. goes public with a market cap of $500 million, zooms up to $10 billion where it becomes “important” enough to be added to the S&P 500, eventually rises to a $15 billion market cap during the final bull market blow-off, but then—in the harrowing tech wreck of 2000-2002–collapses to $1 billion. Studies I conducted while working on Wall Street showed this happened to dozens of S&P 500 firms, giving the index terrible performance. The index became a stealth growth stock fund with a strong TMT bias. Index investors got none of the run-up in XYZ from $0.5 billion to $10 billion, but all of the collapse from $10 billion to $1 billion. No thank you. In that period it was pretty easy to outperform the S&P 500 if you avoided the tech mania—particularly because many non-tech stocks were so neglected they had absurdly low PEs. For example, homebuilders had PE ratios of 5x or 6x.
In theory you might avoid this sad scenario by avoiding an S&P 500 Index fund and instead buying a “total market” fund. But that is a very imperfect solution, because the entire market can have a long-term, ultimately disastrous bias in favor of one sector. Financials, for example, became a larger and larger portion of the stock market between 1990 and 2007 as many new financial companies were created and went public (REITS, mortgage banks, mortgage insurers) while large, well-established firms also decided to go public (investment banks, mutual life insurance companies such as Met Life and Prudential) and some giant non-financial companies (GE, GM) diversified into financial businesses. All of these companies were benefiting from the long-term trend toward lower interest rates, deregulation, and credit creation from 1982 to 2007, and they all got killed by the financial crisis. Index fund investor fully participated in the debacle, including terrible mega-caps like Citigroup.
Right now the glamorous part of the stock market that eventually could mimic tech or financials is healthcare, though maybe not for many years. It has exciting fundamental growth drivers (demographics, new technology, Obamacare, rising healthcare standards in emerging markets), but also quite a bit of financial froth (booming M&A activity, lots of interest from venture capitalists).
To Control Risk, Don’t Fall in Love with Any Sector
Whether you want to “create your own conglomerate” by selecting your own stocks or prefer to buy mutual funds, a key to long-term success is to recognize that Wall Street invariably takes every powerful economic and financial trend to wretched excess. It’s OK to participate in the “hot” sector in a disciplined and sane manner; don’t try to be a stoical contrarian. But control your risk by not becoming hugely over-weight any one sector.
Copyright Thomas Doerflinger 2015. All Rights Reserved.