Indexing Prevails In "Stock Picker's" Market

The obituaries for indexing are beginning to appear. "Stock Pickers On Top: The Wheel Has Turned From Indexing To Active," declared the headline of a recent story in a financial publication. The article trumpeted that the majority of actively managed domestic stock funds achieved the "seemingly impossible"—they outperformed the Standard & Poor's 500 Index on a trailing 12-month basis.

The assertion is indeed true, but barely. Over the 12 months ended March 31, 2001, 51% of average general equity funds outperformed the S&P 500 Index, posting a one-year return of –18.5% compared with the –21.7% return of the large-capitalization-dominated index. (For the same period, 60% of active funds outpaced the –24.8% return of the more relevant, all-market Wilshire 5000 Total Market Index.)

An Urban Legend
While the S&P 500 and Wilshire 5000 Indexes are tough bogeys to beat over long periods, there is certainly nothing unusual about active funds having the edge over the short term. In fact, the S&P 500 Index was outpaced by half of the general equity fund universe in each year from 1991 to 1993.

Like the early 1990s, today's market environment is sometimes referred to as a "stock picker's" market. This financial urban legend holds that under certain market conditions, active managers—through skill, acumen, or superior research—can pick winning stocks and avoid losers. Unlike the alligator living in the city sewer legend, however, there are few teeth in the stock picker's argument.

George U. Sauter, managing director of Vanguard's Quantitative Equity Group, which manages Vanguard's stock index funds, dismisses the notion: "All investors own the entire market. For one investor to outperform, another must underperform. In every trade, one stock picker wins, one stock picker loses relative to the market rate of return."

Mr. Sauter attributes the recent outperformance by actively managed funds to a broad market trend—small- and mid-cap stocks have performed better than large-cap stocks. It would be reasonable to expect that active funds that can invest in the small- and mid-cap issues will come out ahead of both the S&P 500 Index, which is composed mostly of large-cap stocks, and the Wilshire 5000 Index, which is roughly 70% in large-cap issues.

Down-Market Myth
A second, equally specious, myth about indexing is also cropping up: Actively managed funds fare better than index funds in down markets. Supporters of this myth point to two factors that they claim doom an index fund in down markets. First, an index fund is typically fully invested in stocks, so there are no cash reserves to cushion a market drop. Second, an index fund is obligated to track its target index with precision and, therefore, in down markets is destined to decline in lockstep with its benchmark. An actively managed fund, on the other hand, holds some cash reserves and enjoys the flexibility to move to what appear to be the better-performing stocks or sectors of the market.

However, past results indicate that index funds are no more vulnerable to market declines than their actively managed peers. The accompanying table shows that the broad market benchmark held up quite well relative to active funds during two of the most severe market declines of the past 30 years. Perhaps more important, during the recovery period following sharp market drops, index funds have rebounded well ahead of actively managed funds.

Whether actively managed funds as a group outpace the market in any given year is largely irrelevant for the long-term investor. Over a span of many years, indexing outperforms the vast majority of actively managed funds. The reason is that index funds have a sustainable advantage: low costs. A low-cost index fund has annual expenses as low as 0.12%. The average general equity fund has an expense ratio of 1.45%, plus estimated transaction costs of 0.50% or more. The aggregate net handicap of nearly 2.00% makes it virtually impossible for the majority of active funds to outpace low-cost index funds over the long term.

Actual investment results over the past decade bear out this assertion. During the ten years ended March 31, 2001, the Wilshire 5000 outperformed 63% of all actively managed funds (the S&P 500 outperformed 74%). The reports of the death of indexing, then, appear to be greatly exaggerated.

All comparative mutual fund data are from Lipper Inc.

Indexing Versus Active Management in Bear Markets

Actively managed funds generally offer no greater protection than index funds in a down market, and lag during the eventual rebound. While the cash held by an active fund may cushion the decline, their higher costs serve as a drag in up and down markets.

Thanks to Vanguard for the information contained in this article.

This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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