Is Index Fund Investing Overrated?

By in Asset Allocation, Investing, Money Management, Mutual Funds | 10 comments

Is It Possible to Beat the Market?

can you beat the market

In Jeff Somer’s NY Times article,  “Beating the Market, as a Reachable Goal”, Robert A. Olstein is insulted by the arguments in favor of index funds. He claims that the index fund approach is a reach for mediocrity.

Olstein goes on to site the stellar performance of his Olstein All Cap Value Fund. According to the NY Times article, since inception (in 1996) through November, 2013, and including fees, the fund returned 10.7 percent annualized. That’s 2.4 percent better than the S & P 500 stock index. He also claims his fund slightly outperformed the 10.3 percent return of Warren E. Buffett’s of Berkshire Hathaway.

Olstein claims his out-performance was due to exceptional skill and analysis.

To sum up Ostein’s performance and back it up with data; since 1996, on average, his All Cap Value Fund beat the S & P 500.

Does that 18 year average out-performance prove that an index fund approach is mediocre? 

Does the reality that a few managers may beat the market, recommend that investors should disregard the popular trend towards investing in index funds?

Before jumping to conclusions, let’s consider the research in favor of index fund investing.

Index Fund Investing Research; Active versus Passive Management

Rick Ferri and Alex Benke took on an ambitious study of index funds. In “A Case for Index Fund Portfolios” (downloadable white paper) the authors’ completed an exhaustive study comparing the average performance of the market (as evidenced by an index fund investing approach) and that of actively managed mutual funds (using the survivorship-bias free CRSP database). 

Ferri and Benke describe their approach:

“We compared and documented portfolio performance
using actual fund performance in several different
scenarios. We varied the holding period of the portfolios,
varied the number of asset classes in the portfolios,
measured the performance of actively managed
portfolios that held more than one fund in each asset
class, and tested a subset of active funds with lower fees
to see if there was a meaningful change in the active fund
portfolio success rate.”

This research compared active versus passive investing approaches in 5,000 simulated trials. 

How Were the Mutual Funds Selected?

The CRSP survivor-Bias-Free US Mutual Fund Database includes objective investment styles and categories and is considered the gold standard data base of mutual fund information. The active funds, after being categorized, were randomly selected so that their asset classes mirrored those of the index funds. All funds included in the study were available and not closed during the entire periods of study.

Investing Scenarios

This article will look at a few of the researchers six scenarios.

Scenario 1 included a three fund portfolio with taxable bonds: 40% US Equity, 20% International Equity, and 40% US Investment Grade bonds. This portfolio is a very popular asset allocation among investors (60% stocks: 40% bonds).

In this scenario, during the 16 year period studied (1997-2012), the index fund portfolios beat the actively managed portfolios 82.9% of the time.

Scenario 3 used Multi-Asset Class Portfolios and increased the number of asset classes. Only a 10 year period (2003-2012) was used due to the short life of several of the index funds. This scenario compared from 3 to 10 asset classes. 

The ten asset classes index fund portfolio beat 89.9% of actively managed fund portfolios using 5,000 simulated trials. 

This chart shows the 10 index funds the research used for this analysis.

10 index fund portfolio

The remaining scenarios considered a fee adjusted comparison along with a risk adjusted evaluation.

I encourage anyone interested in this topic, to review the entire whitepaper.

For the remaining readers, their conclusion regarding index fund investing versus active management followed that of Vanguard’s research along with that of recent Nobel prize winner Eugene Fama.

The benefits of index fund investing continued over the various simulations. The authors concluded that in both the short and long term, it it difficult for investors to beat a diversified portfolio of various asset classes. 

So what is the conclusion? We started with a description of a fund manager who outperformed the indexes. And continued with an exhaustive study of index fund investing versus active management, under various scenarios.

Does that suggest that everyone should invest only in index funds?

Is Index Fund Investing Overrated? Can Active Funds Beat the Market?

In response to question 1, “Is index fund investing overrated?” No.

In response to question 2, “Can Active Funds Beat the Market?” Yes.

So where does that leave the investor?

Both Somer’s NY Times article and Ferri and Benke’s research agree, it is possible to beat the market, but it’s unlikely.

And to add to the difficulty of beating the market, is the reality that only know after the fact, will you discover who beat the market.

Is there any proof that even though Olstein’s fund beat the market for the past 18 years, it will continue for the next?

Do we know for certain that the active portfolios which beat the market every year do so based upon skill and not luck?

As an investor, you may want to take your chances at an active approach, just realize, that your chances of beating the market on an annualized basis, year over year are unlikely.

A Unique Approach to Beating the Market

Some investors enjoy stock picking and researching various assets. There are others who go for market timing, momentum, and other approaches. And what about the opportunity to invest in commodities and alternative asset classes?

One investing alternative for those interested in attempting to beat the market; take a portion of your portfolio and try your hand at active management. If you beat the market, then you have increased your total returns. If not, then you haven’t damaged your return too much.

In the end, the question remains, can a market beating return be explained by skill or luck?

What is your approach, active or passive investing?

    10 Comments

  1. Does Olstein understand that comparing an “all cap value” fund to a broad large cap fund is completely irrelevant? Hard to take someone seriously when they don’t even know how to choose a suitable benchmark.

    Matt Becker

    June 30, 2014

  2. My short answer is no, Index Fund Investing is not overrated. Most actively managed funds do not beat the major market indexes and that is all the evidence I need. Lower transaction fees and mgt fees make up for any benefit a fund manager may provide for most funds. There is always the exception but for most investors, index funds are the way to go.

    Paul @ The Frugal Toad

    June 30, 2014

  3. Great post. I fully understand the difference between active and passive investing. For my own opinion, I prefer active investing. It sounds more effective.

    Marie @ 724 Credit

    July 1, 2014

  4. Excellent debate…thanks for the well-written article Barbara. I believe active investing is a failure for most investors because they engage in market timing and momentum investing. They allow their emotions to influence their investment decisions, many time close to important market turns. They also try to “beat the market” on too short of a time horizon.
    Investors who base their investment decisions on valuation can employ a more active investing style. It does require more work and an ability to control ones emotions. Many investors are unable to do one or the other.
    I have written an article, “Beat The Market – Rethinking Your Goals” on this subject for anyone interested in further reading: http://arborinvestmentplanner.com/beat-the-market-rethinking-goals/

    Ken Faulkenberry

    July 8, 2014

    • Hi Ken, I agree that a more sophisticated investor may want to tweak the traditional index investing approach a bit. For example, at the trough of the market during the most recent recession, I invested some additional cash into my portfolio (existing index funds in line with my asset allocation), in order to take advantage of what I understood to be attractively valued asset classes. Valuations do matter, but one can also just employ a strict dollar cost averaging strategy into index funds and yield excellent results (historically). Thanks for your thoughts.

      Barbara Friedberg

      July 10, 2014

      • I personally do not like the downside of index investing. I prefer some cushion and not to go that far down like an index.

        Socrates

        August 20, 2014

    • In my opinion, it’s not about active vs. passive mutual funds; it’s about one’s goal, needed rate of return and how much will be invested each year for that goal to be achieved. The biggest failure is not in the funds a well informed investor chooses, but his/her behavior through up and down and flat markets. More investors suffer big losses in returns due to a lack of discipline, asset allocation, and not being in high quality funds for longer than 5 years. According dalbar investors average annual return is about 3.5% a year. If investors were more disciplined and focused on asset allocation I think anyone can get to their financial goal. I personally prefer active mutual funds through a broker. Yes there extra fees, but in the long run, over ten years those fees are very low. I’ve had annualized returns of 17% for the last 7 years, and continue to pile in the cash each year. I focus on ten year performance and my asset allocation, more and staying disciplined to that asset allocation. I give the funds that I invested in time to compound and grow each year. I rebalance about twice a year, dependent upon the market and where my asset allocation sits verses my target asset allocation. Always bringing it back to the target allocation.

      Socrates

      August 20, 2014

      • Hi Socrates,
        Thanks for your opinion. I’m curious about the funds you have chosen as well as your asset allocation. A 7 year average return is quite impressive, especially given the -38% return of the S & P 500 in 2008.

        Although most active investors fail to beat the market averages, obviously some investors do prevail.

        Write in and share your asset allocation and fund choices. Let’s continue the conversation.

        Barbara Friedberg

        August 21, 2014

        • My asset allocation is as follows:
          Income 20%
          Growth and income 40%
          Growth 20%
          Aggressive growth 20%

          Right now I am a little overweight in growth and income and building an over weight in growth.

          For funds I’m using the following(the first 4 funds I’ve been in for over 1o years)
          American funds
          Growth fund
          Fundamental investors
          AMCAP
          Bond fund
          New perspective
          Capital income builder
          Small cap
          New world
          Developing world growth and income
          Balanced fund
          Franklin income
          Franklin utilities
          Franklin real return
          Franklin total return

          Socrates

          August 21, 2014

          • @Socrates, Thank you for giving the readers a peek into your portfolio. It looks as though you’ve given your asset allocation and funds a lot of thought. We wish you continuing out-performance over the years. Keep us posted!

            Barbara Friedberg

            August 23, 2014

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