A couple of days ago the WSJ reported big news in the mutual fund world\u2014active 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\u2019s 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\u2019s mid-cap funds tended to outperform large-cap funds.<\/p>\n
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:<\/p>\n
Investment Conclusions<\/strong><\/p>\n The Trouble with Index Funds . . .<\/strong>\u00a0<\/strong><\/p>\n . . . is that you will fully participate in the stock market mega-manias that develop over time\u2014energy 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 \u201cimportant,\u201d \u201crepresentative\u201d stocks \u2013 that is, after they had run up in price<\/strong>. This was disastrous for index fund investors, who got little of the upside but all of the downside<\/strong> on dozens of \u201chigh-flyers\u201d 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 \u201cimportant\u201d 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\u2014in 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<\/strong> of the run-up in XYZ from $0.5 billion to $10 billion, but all <\/strong>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<\/strong>\u2014particularly because many non-tech stocks were so neglected they had absurdly low PEs. For example, homebuilders had PE ratios of 5x or 6x.<\/p>\n In theory you might avoid this sad scenario by avoiding an S&P 500 Index fund and instead buying a \u201ctotal market\u201d 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.<\/p>\n 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).<\/p>\n To Control Risk, Don\u2019t Fall in Love with Any Sector<\/strong><\/p>\n Whether you want to \u201ccreate your own conglomerate\u201d 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\u2019s OK to participate in the \u201chot\u201d sector in a disciplined and sane manner; don\u2019t try to be a stoical contrarian. But control your risk by not becoming hugely over-weight any one sector.<\/p>\n Copyright Thomas Doerflinger 2015. All Rights Reserved.<\/p>\n <\/p>\n","protected":false},"excerpt":{"rendered":" A couple of days ago the WSJ reported big news in the mutual fund world\u2014active 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 … Continue reading \n