“Average” – More Motto Than Maxim

Written by John Osbon on February 4, 2014

Average is above average
The evidence is overwhelming. Index funds, designed to deliver the market return of an asset class, have consistently outperformed the majority of actively managed mutual funds. Period. Still, many investors and advisors are unwilling to accept this idea. Indexes seem “average.” Average seems lame. And who wants to be lame? It’s a costly attitude.mission-statement

A word accident
Remember that “average” is a semantic accident. When the famous index of 30 stocks was named the Dow Jones Industrial Average, that word became ever associated with indexes. If only they had only correctly named it ‘The Dow Jones Industrial Index”!  Oh well, we’ll have to live with it.  The DJIA has been way above average despite its name.

Numbers don’t lie
The numbers are clear. Actively managed funds, on average, can’t keep up with their relevant benchmark indexes. A 2013 report from S&P showed, once again, that over the preceding 12 months, 54 percent of domestic equity funds trailed the S&P Composite 1500. Over three and five years, 79 and 72 percent of funds underperformed, respectively.  The longer the measure the better indexing looks.

This pattern repeated for large caps, mid caps and small caps, for growth and value, and for real estate funds. The index advantage also held true for global, international and emerging market funds over all three time periods. In many categories, the index beats more than 80 percent of funds.

Same old good story
This is no new phenomenon. When we discussed this topic a couple years ago, we shared data going back to 1980 that told the same story – indexes consistently beat the majority of active funds. Another recent report shows the performance advantage of portfolios of index funds over active fund portfolios. Same results.

By the way, none of these stats take into account after-tax returns, which further favor low-turnover, low-capital-gains-distribution, low-tax index funds. After tax, index funds do even better by comparison.  And it’s after-tax that matters most to the tax paying individual – you.

But how can it be?
…But how can “average” index funds beat the majority of funds in their respective asset classes? 

Thanks to transaction costs, management expenses and, simply put, bad guesses about which stocks will perform best, the average fund does worse than its index. The numbers show this clearly. As much as we might be persuaded to think that a smart manager would consistently do better than average, it just rarely happens. When it does, the problem then becomes how can you predict which special manager will do it…in advance.

The Million Dollar Question
The million dollar question remains: why would investors pay active fund managers to deliver performance that, on average, has so consistently lagged humble, but far from average, index funds? You shouldn’t pay, don’t need to pay for what you don’t get.

Give us a call at 617-217-2772 – we’d love to hear what’s on your mind


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