Is Index Fund Investing Overrated?
Is It Possible to 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.
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.
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?