Good article and comments. But I think the trend is for less diversification and more toward solid value assessments in building a winning portfolio. It seems a lot of investors, tired of diluted gains, are starting to latch onto the whole movement around value-based investing.

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@ Stock Research

Thanks. I agree folks are picking up on the value investing trend, but I think the main point that I wanted to make was not to overlook performance just b/c you’re hung up on low expense ratios. As long as I’m getting what I’m paying for, I’m a happy camper.

Those people who really cleaned up in the last 30 to 40 years made their big money by picking exceptional companies and avoiding the laggards. This coming from someone who has been sitting on index funds for the last decade and basically making no money, so it was an observation from my own portfolio.

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Aha! Your post confirmed my suspicion that my index funds suck. They’ve trickled in some returns over the years, but quite frankly, I’ve been doubting the ability of the funds to do me any real good. I agree with what you said re: index funds being “safe” and easy to explain. This is precisely the investment paradigm I’m working to break out of. Easy and safe doesn’t seem to make much money.

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@ Drea

Precisely! Bill Gates or John Chambers didn’t get rich by being diversified. Now, you and I probably are not sitting on a few million shares of a company we created, but with risk comes reward and they’re good examples of that.

General rule of thumb says be diversified in the majority of your accounts but it never hurts to speculate with 25% of your portfolio.

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En Garde!

http://socalsavvy.blogspot.com/2008/09/en-garde.html

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Ahhh… faulty logic it is when you ignore the rule of regression to the mean!

It’s nothing personal; I think we’re just arguing about different time frames. Over the long run, which retirement planning for 25-year-old is, the data shows that very few mutual funds will beat the market. Some will, of course, but divining which ones those are is hard.

I’d say that while many companies are multi-national today, there is ample proof that adding large and small cap international indexes brings down the risk in a portfolio while adding additional unique return. With the advent of the internet, no one is confined to the US markets. Therefore, I see no weakness with indexing due to that point.

I think you are smart to write the article!

It makes people think about the methods they choose to invest in and the underlying assumptions they hold. Please don’t think I’m picking on you, we’re just both expressing opinions based on the lessons we have learned (professional or academic- both have their merits).

The only thing that I think you were guilty of was being a little harsh in tone! If you want to suggest an alternative point of view, it’s not nice to project anyone’s demise.

See the problem with the dates you picked (although with good intentions, being 10 years from your post) is that they happened to be good years in general.

I’d say try running the same scenario with mutual funds over 40 or 60 years- timelines that retirement portfolios use (although that would be impossible with your current mutual fund pick as it is only a decade old).

So I guess the only thing left to clarify is: is 7% returns dead money? What about 10-13%? What do you think a person should expect of their portfolio returns and at what risk?

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You sound like a lover of statistics… no wonder I’m having a hard time swaying your logic. While I’m a HUGE proponent of the numbers, investing doesn’t always follow the numbers. That’s a big admission b/c I’m a former pharma consultant, so I can obsess about importance of P values until I’m blue in the face.

I’m sensing your hesitance is about picking a mutual fund or individual stocks on your own. A very common problem, but that is where knowing how to do the research to pick the winners or hiring someone to do the research is in your favor. Which is why I suggested for those who can’t do them on their own, hire someone that has a history of outperforming the broader markets. That said, you have to sort out the posers and shovel through the BS to find the real keepers.

I’m not sure if anyone has beaten the major indices every year, but I don’t think it’s realistic to set that high of a standard. Would you bench Kobe Bryant for going 7 of 10 from the foul line? Probably not. But you have to acknowledge the fact that some stars shine brighter than others, which is why picking the right people to run your money works in your favor.

As for an annual 7% return, that is acceptable on a long enough time horizon. Problem is, you can get single digit returns like these in the bond market. Heck, I’ve got 6.0% on my savings account, which obviously won’t last forever, but can be found quite easily in fixed income market. Guy’s like PIMCO’s Bill Gross do very well.

I don’t mean to continue bringing up the 10 years issue, but many people suggest that including the great bull market of the past is a serious liability. America has strong odds going against this type of growth period b/c lets face it… history shows those types of bull run markets are very difficult to continue over a long time horizon. I’m certainly not putting my faith in having another one. I’m looking elsewhere to other international markets for those types of returns.

If you’re only 25 years old, any financial planner would tell you shoot for higher returns in a high risk, but diversified, portfolio. Probably something in the small cap or mid cap companies with strong growth prospects.

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Hi, I wouldn’t have bothered to reply but the “trolling” title of this post on Carnival of Personal Finance prompted me to speak up. Nobody’s making you invest in index funds but it is irresponsible to say they are a “bad investment.”

Here is what one of my favorite financial gurus, Scott Burns, says about Index vs. Managed Funds:

**********Begin Scott Burns quote*************
The best way to get a grip on this is to read one of the SPIVA reports, a quarterly report from Standard & Poor’s that measures the performance of managed funds against major indices. Unlike most reporting, this one adjusts for survivor bias. Here’s a link to the most recent report: http://www2.standardandpoors.com/spf/pdf/index/SPIVA_2007_q1.pdf . As you’ll see from the report, active management doesn’t come out very well and they are only measuring a 5 year period. The longer the time period, the greater the odds that the index fund will beat managed funds.

. . .

This report verifies research I have been tracking since the early 70s. This research, done by a multitude of different parties, has consistently concluded that about 70 percent of all active managers fail to beat their appointed index benchmark. This doesn’t mean the 70 percent figure is consistent, it actually moves up and down over long cycles. But the general range is from about the 50th percentile to the 90th.

In rising markets the index funds have an advantage over managed funds because they have little or no cash so they get 100 percent of a rising market. In declining markets the index funds have a disadvantage for the same reason— while active funds hold more cash and are slightly less vulnerable to declines, index funds feel the full drop.

Scott
****************end Scott Burns quote ******************

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I own index funds myself (had you read the article) but my S&P based index fund is my worst performer.

Your own research states 30% of MFs beat their index benchmark. I’m saying if you do your homework, you can find these managers yourself and come away with a far better return.

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Just curious what savings account you have that was returning 6% as of 9/10? Just curious b/c according to bankrate.com, there isn’t a savings account close to that now. I realize that the rate has dropped recently, but nowhere near enough to bring it down from 6% to the mid-3% rate that you can find now.

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@ Brad,

I’m using a bank I found through http://www.CheckingFinder.com. Searching for the highest rate, I found a small bank in Missouri. It requires you use a debit card 10x a month and 1 direct debit/deposit per month. Which in most cases, is fairly easy to accomplish.

I love bankrate.com, but it occasionally misses the smaller banks. Which is why CheckingFinder.com works so well – at least in my case.

Let me know if it works out for you.

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yeah, owning actively managed funds is better. if you own a time machine.

nobody ever claimed that an index beats every managed fund in every time period; just that a) the appropriate benchmark index fund will beat the overwhelming majority of actively managed funds over periods longer than 10 years, and b) nobody can reliably identify the small number of funds that will outperform. though there _is_ one strong indicator of a truly superior managed fund: it will be closed to new money.

on the other hand, it is hard to make a graph out of this line of reasoning, so lots of people will continue to ignore it.

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@ misanthropope

There are a few good managers out there, and yes I agree, finding them is becoming more difficult due to any number of factors. Then again, difficulty is intensified when the search for a good manager begins with determining if he/she lost less money than the comparable index, as the case in 2008.

One other thing to consider is that the S&P 500 is essentially a mutual fund in itself. Standard & Poors decides who gets in or out based on the decisions of a committee – just like an actively managed mutual fund.

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Interesting … never thought of it that way.
I always assumed index funds were great investments.

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@ TStrump

Thanks for commenting.

My opinion certainly isn’t a popular one, but it’s an interesting way to dissect the S&P 500 index. I’m a trader so being a passive investor is difficult for me to absorb, but make your decision on picking actively managed funds very carefully if you go outside of the passive realm.

Vanguard also has a few managed funds that held up reasonably well.

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“There are a few good managers out there”
——————————————–
Up until a few years ago, Bill Miller was considered among the best in the business.

Unfortunately, most people started moving into his fund after his success [major inflows began in 1997, the 7th year of his 15 year streak] and before his failure, usually called return chasing. These people have now underperformed against the S&P during this time frame, largely helped by his huge holdings of BSC.

As for picking mutual funds, they are a scam. But, don’t take my word for it. Listen to what Jack Meyer, the former president of Harvard Management Company had to say:

http://www.vanguard.com/bogle_site/sp20060406.htm

“Most people think they can find fund managers who can outperform, but most people are wrong. You should simply hold index funds. No doubt about it.” ”

David Swensen, CIO of Yale University Endowment fund says:

“A minuscule 4% of funds produce market-beating after-tax results with a scant 0.6% (annual) margin of gain. The 96% of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8% per annum”.

And William Bernstein, author of 4 Pillars of Investing says:

“While it is probably a poor idea to own actively managed mutual funds in general, it is truly a terrible idea to own them in taxable accounts…taxes are a drag on performance of up to 4 percentage points each year.

Bogle’s book, Common Sense Investing [c. 2007] dissects managed mutual funds going back to 1970 [following information gathered from pages 79-88 of this book]. There were 355 managed funds that were in existence at that time.

223 of them have gone out of business. 15 of them beat the market by 1% and 9 others have beaten the market by more than 1% [2.5%]. Those 15 funds that have beat the market by 1% will more than likely charge approximately 1% or more than an index fund, making their return over the S&P nil.

But, the problem with these 9 funds with superior returns is that 6 of them achieved their superior returns BEFORE large money poured into the funds. They have been lackluster since. 3 funds out of 355, that’s it – less than a 1 in 100 chance.

Now, if you truly believe as an investor that you are capable of beating the market as a whole over the long run and are willing to put in the effort to back up that belief, then I would fully support someone doing that. I don’t agree with it personally but if someone is willing to accept the risk themselves then it is what it is.

However, I would absolutely never, under any circumstance recommend ANY actively managed fund to someone for long term investing.

Nor would I personally want to spend so much time for the necessary research for the slim possibility that I will beat the market as a whole over the next 40+ years.

Do I think that most people, that independently manage their own portfolio, will be successful? No. I believe you have less than 1 in 100 chance of being successful if you are of high intelligence – say close to genius, and dedicated to the effort and research necessary. Otherwise, I recommend index funds to everyone else. If only 3 out of 355 professionals can do it with their research and access to information then I have little confidence that a non-professional can.

Therefore I will enjoy the most passive form of investing that minimizes my expenses [both management fees and taxes] and allows me to enjoy almost all of the total market returns and accept that I am in the 85th to 90th percentile in terms of investment returns earned by investors as a whole.

Call it lazy, I call it common sense.

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So let me get this straight… you prefer to own the C+ and below the bell curve performers in your portfolio? Who in their right mind was buying financial companies — a major component of the S&P 500 — in 2008?

Most of us who trade for a living were shorting the financials every chance we got until the short sell ban was enacted, and then we just shorted the SPY or bought the ultra short financial ETFs (e.g. SKF), which of course, crushed anyone who owned index funds. So why would you knowingly want to buy something with that much short interest and had every indication of getting creamed or having their stock price eroded down to zero? Think Lehman Brothers or Bear Stearns.

This is probably my biggest argument against index funds — because there is are a few bad apples in the group that will ruin the bunch. Just like financials did this year, and why I was chastised when I first wrote this post in September.

Index funds are doomed to suffer the same fate as the perceived strength of the American economy. And for the reversion to the mean argument, it’s my contention that most of the rise in the market during the 1990s and 2000s were essentially bubble based and built upon leverage. Pull a chart of the S&P 500 from the 1950s until now (make sure it’s linear, not logarithmic).

The meltdown in October was an excellent example of this wouldn’t you agree? Try finding an investment bank out there today who’s willing to take on a 30 to 1 leverage ratio betting on the market and inflating stock prices.

As for your research, I do agree with 90% of it. I am a partially passive investor since I own index funds myself in my IRA, so that if I’m wrong, I don’t totally screw myself. But as you can see, I’m willing to do the hours of necessary research and I actually have profits this year unlike most people.

You’re exactly right that most mutual fund managers couldn’t find their butt with 2 hands and a flashlight, but that’s because (in my opinion) managers who don’t outperform over an extended period of time simply don’t know how to trade.

I’m not talking about market timing, but I’m talking more about the ability to rotate out of sectors that are overvalued and into undervalued sectors. My best example of this was during the tech bubble of 2000 when Kevin Landis was holding semis at P/Es > 500 or dot coms with P/Es in the negative 10,000 arena. Ken Heebner’s CGM Focus Fund did the same thing by staying overweight in commodity stocks far too long in mid year. Once the technical breakdown in the oil market occurred, it was a clear warning sign to sell or get short.

You are also correct that it is increasingly difficult to trade once you become a multi billion dollar fund. I imagine it’s difficult to disguise blocks of 50,000 to 500,000 shares on an electronic exchange without raising some eyebrows.

However, I’m not willing to completely give up on actively managed funds. Perhaps one of the biggest problems is that the best money managers have been chasing hedge fund salaries and performance bonuses. You have probably heard about a few that imploded this year, but there are a few who did well. Sadly, one of the best decided to abandon the business (Andrew Lahde – profits up 1000% or so) and write a tirade why smoking pot should be legalized. Go figure!

Thanks for your comment!

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hot air

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@ Tom

please elaborate.

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This advice is really going to help, thanks.

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Matt Reply:
April 6th, 2009 at 11:35 am

No problem. Glad to help!

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You don’t seem to have addressed the thrust of the index fund argument (at least as described on Wikipedia (http://en.wikipedia.org/wiki/Index_fund#Economic_theory)), which is essentially that the cost of identifying undervalued/overvalued securities on average is higher than the gains that can be achieved by doing so. Essentially, if it’s possible to do better than the market, then “smart” investors will do so and market prices will quickly adjust to reflect the “true” value.

I’m no trader, and this is an academic argument, but you haven’t addressed it. You claim that you _can_ do better than the market by pointing to particular funds that have, but that’s useless without a cost-effective way to identify such funds _ahead_ of time, and the index fund thesis is that doing so usually costs more than one can gain.

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Matt SF Reply:
December 30th, 2009 at 10:20 am

Dave,

I think you answered the question yourself with the “identify such funds ahead of time” statement.

That’s the whole premise of becoming a stock picker yourself, or sticking to actively managed funds. You’re rewarded for making the right calls versus getting what everyone is getting via an index fund. Naturally, you reap the rewards or suffer the penalties by breaking away from the herd. In some rare cases, you can get an actively managed fund for free by selecting the right stocks (but they’re subject to the same market pressures as everything else).

Naturally, not everyone is willing spend copious amounts of time to manage their own portfolio (fee free I might add) or should they attempt to open themselves up to the fairly massive risks that individual stocks can have. The reality of the situation (I’m not much of a theory person) is that I’ve gotten zero gain on the index funds I bought in 2000 (S&P is down ~20% for the decade without dividends). I’m patient, but a decade long wait is bit much.

The thrust of the anti-index fund argument (and I’ve written several pro-index fund posts as well) is that they’re a “compromised” investment class in the sense that they are required to hold all the equities in the index they track. So they get to hold the best companies, but they’re also required to hold the laggers as well.

Call me crazy, but I’d rather build a portfolio of stocks I consider A, B, and C stocks rather than select a majority of C stocks with equal weights of A, B, D, and F stocks (see the bell curve section).

Thanks for commenting!

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Excellent points. I do not understand all of the hype behind index funds. Passive investing never allows you to outperform the general market.
.-= Mark´s last blog ..Your 2010 Investment Playbook =-.

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Matt SF Reply:
January 9th, 2010 at 4:21 pm

Thanks Mark. This post was met with tremendous resentment (as you can see) so index funds definitely have their proponents.

I own them and think they make a solid low cost hedge against any screw ups I might make in my own trading accounts, but I don’t think they’ll put any serious growth prospects in a portfolio unless you specifically go for the small to mid cap index funds or maybe the Russell 2000 index fund.

I think what many people don’t seem to understand is that the indices are just a barometer of the economic climate, and when nearly every stock in that index is facing a bad business climate, index funds aren’t going to provide as much protection as they think they will.

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Good post – we are both black sheep. I knew the crash was coming 3 years ago when a friend of the family talked about “reading a book” on index funds, how they were putting a very high percentage of their savings into them, and how it was just going to go up and up – they had it made. I was smiling with the look of the devil’s advocate. I just said “be careful” as there was no way I could burst his bubble.

A couple months later, after attending a talk with one of the hot shot economic analysts at our firm (making their predictions for 2008) I had questions, but couldn’t raise them in the public forum for fear of being flogged on the spot and probably escorted out of the building by security and asked not to return to work the next day. So I later sent the analyst a few pointed questions and asked for his thoughts (I know he read it because I sent it return receipt) and never received a reply.

The key question I had centered around index funds, people pumping money into them and how it was providing a false sense of a strong market. In essence that it was a self-fulfilling prophecy. At the time, index fund investing was on a big upswing, Bush was advocating letting people invest a portion of their Social Security contributions (in the market), HSAs were coming (more investing in the market), 529 college savings plans were pumping money into the market, then the index funds needed to buy more furthering demand for stocks, and so on. I asked the analyst “I see this happening, and it is predicated on the index fund investor not being trigger happy, putting his money in and letting it grow. However, don’t you think that when the music stops and the index funds get hit with redemptions from Average Joe (who says he’s a long-term investor, but will dump everything if he sees he’s lost 10%) we are going to see this upward spiral work in reverse when the index funds have to sell, put downward pressure on stocks, which invites more selling, etc., etc.?” Well, I don’t remember who that hotshot analyst was, but the way things have played out makes this keyboard jockey smile knowing he was right, and there is absolutely know reason to listen to what Wall Street tells you or who recommends what – because they don’t have a crystal ball or any special information.

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If you invested 5 years ago, the S&P beat CGMFX. At best, only 20% of managed funds beat their index in any given year. Lots of work to find the 20%, and they don’t stay the same every year so you are fighting a losing battle.

Sure it’s possible, but it’s anything but a slam dunk and difficult to achieve year after year. If you can do it hats off to you!

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Matt SF Reply:
February 21st, 2010 at 1:01 pm

That’s true, got to give it to you there. Heebner is a home run swinging type of fund manager, and he didn’t get out of his oil bubble stocks quickly enough, and quickly thereafter, bought into the financials way before the bottom.

There are a couple fund managers with good 10 year performances, so I might post a few of them at a future date.

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