“Average” is anything but

Dow Jones & Company has contributed greatly to the world of business and investing, most notably through its gold standard news outlet, The Wall Street Journal. But in 1896 when the company named its flagship market index the “Dow Jones Industrial Average,” it created a considerable can of worms that is still open and wriggling today.

The problem is a single word, one that sounds innocuous enough: “Average.”

Synonymous with market

The Dow Jones Industrial Average (DJIA) has become literally synonymous with the stock market as a whole. Commentators and investors routinely summarize the entire state of the market with “The Dow hit 13,000 today,” or “The Dow reacted quickly, falling one percent.” DJIA is such an iconic market symbol, no more need be said.

Nonetheless, Mr. Dow and Mr. Jones picked a lousy name. By calling it an average, the founders equated indexes with average performance forever after.

“Average” is far above average

Funds that track indexes like the Dow get a cold shoulder from most pundits and many investors because they are perceived as mediocre, middle-of-the-pack performers. It’s a reasonable perception – an unmanaged buy-and-hold index can’t beat active funds managed by seasoned experts.

It’s a reasonable perception, but it’s not true.

It turns out that 84 percent of actively managed mutual funds failed to match the performance of their relevant Standard & Poors benchmark indexes in 2011. That’s right, only one in six active funds beat their respective benchmarks, according to this press release from S&P.

That’s a big win for indexes like the S&P 500, S&P MidCap 400, and others – far better than “average.”  See performance comparison chart.

Consistent pattern

Was 2011 just an anomaly? Well, it definitely was a particularly bad year for active funds versus their indexes. But previous years, though a little less bad, still show active funds, on average, finishing behind their relevant indexes. According to S&P:

• From 2009 through 2011, about 56 percent of stock funds underperformed relative to S&P benchmarks.
• Over five years, 61 percent underperformed.
• Going back 10 years, approximately 57 percent underperformed.
• Underperformance by active funds spanned all capitalization sizes, domestic and international, and real estate funds.

If ten years isn’t a strong enough track record, let’s go back to 1980. According to John Bogle in his book Enough, the S&P 500 offered a 12.3 percent annualized total return from 1980 to 2005, well ahead of the average equity fund at 10 percent.

What do you get for your money?

With a long track record of indexes finishing ahead of the average active fund, the obvious question is why anyone would pay the higher expenses of actively managed funds to get performance that, on average, falls short of their index counterparts?

Sure, each year some active managers beat the benchmarks, even after higher expenses. But can you identify them in advance? What information would you have used a year ago to pick one of the 16 percent of better-than-index managers? It just doesn’t seem like a battle investors can expect to win.

I encourage investors to stop trying to swim against the strong current of data that shows how “average” indexes consistently outperform average active funds and take advantage of the market returns and low expenses of index ETFs.

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