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Should Fund Managers Be Expected To Outrun The Bulls?

So the stock market barreled along to new records in the first quarter of the year. Big deal. You, the investor, want to know how your money manager performed. Did he beat the market? Should you expect him to?

The very phrase “beat the market” implies that there is a competition. Most managers, I’d guess, are competitive folks. They do not like to admit that they come off second best to an arbitrary, unmanaged and seemingly unintelligent opponent like “the market,” as measured by the Standard & Poor’s 500 or another market index. If your performance trails “the market,” this logic goes, you must not be as sharp as the rest of the crowd.

Why, then, do so many stock-pickers fail to match the S&P 500? Are they somewhat dull - or is “the market,” as represented by the index, a lot smarter than we think?

Efficient Market Theory
Before we try to answer that question we have to identify which “market” we are talking about. The S&P 500 is the prototype “large capitalization” stock benchmark. It measures the performance of the biggest, most established, most widely traded and most closely watched stocks in the United States, which remains the world’s pre-eminent stock bazaar. Except when someone is breaking the law, everyone trading these stocks is working off the same publicly available pool of information, digested by the same hordes of analysts.

Economists tell us that in efficient markets, stocks are fairly priced based on public information and accompanying expectations. Thus, in an efficient market, the idea of an “undervalued” stock is nonsense. All stocks in an efficient market are appropriately valued, this theory states.

A market’s efficiency can be debated, but I am confident that U.S. large-company stocks make up the most efficient, or at least the least inefficient, market environment. Stocks like Intel, Microsoft, and IBM have scores of professional analysts following their every move. If Intel warns of disappointing earnings, the market immediately adjusts its opinion of value, as it did in the beginning of March.

If we buy into the Efficient Market Theory and assume that the market generally has fair and correct values, why would we expect a manager to outperform this rational market over the long haul?

Putting the Performance to the Test
The Vanguard Index 500 mutual fund has become the poster child for “passive” investment. Rather than try to outperform the S&P 500, this fund’s managers simply try to duplicate the index’s performance as closely as possible, and it usually succeeds within a tenth of a percentage point or so. This allows us to use the Index 500 fund to test the performance of all those stock-pickers out there, or at least the ones who manage competing mutual funds.

Digging through Morningstar’s mutual fund database, I found that the Index 500 fund has outperformed 93% of large capitalization domestic equity funds over the last three years. Take that statistic out 5, 10 or 15 years and it beats 89%, 84%, and 91% of all large capitalization domestic equity funds, respectively.

In search of a fund better than the Vanguard 500 Index, I screened for funds that have beaten the index fund over the last 3-, 5-, 10-, and 15-year periods. (By definition, of course, this screen eliminates any fund that is less than 15 years old) Sifting through Morningstar’s 9,000 funds from the February 28, 1998 release, I came across six funds that outperformed the Vanguard Index 500 portfolio in each of those periods. The winners are:

Large Cap Funds That Consistently Beat The Vanguard Index 500 Fund:

FundObjectiveTotal Holdings
Fidelity Select Financial ServicesSpecialty-Financial35
Fidelity Select Health CareSpecialty-Health62
SIFE Trust A-1Specialty-Financial93
SequoiaGrowth15
Legg Mason Value Trust-PrimaryGrowth48
Guardian Park Avenue AGrowth450

 

All six funds actively try to outperform the market. But these funds hardly seem to be good alternatives to the Index 500. The first three on the list invest in only a specific sector of the economy. If the sector falls into disfavor, these funds are likely to fall with it. The Sequoia fund is closed to new investors and with only 15 holdings, is a very undiversified (and therefore risky) fund. Legg Mason’s Value Trust - Primary class offering has 43% of its assets in its top ten holdings. If a few of these stocks take significant hits, the fund likewise may run off course quickly. Guardian Park Avenue A fund has a nicely diversified portfolio of 450 stocks, but if you add in the 4.5% front-end load (sales charge), this fund does not beat Vanguard’s Index 500 fund over the last three or five years.

Less Tax Efficiency, More Risk
Most Sentinel readers are particularly sensitive to taxes in their portfolios. Most active portfolio managers trying to get to the top of the charts in Money magazine are not. Thus, many active managers have high turnover rates in their portfolios, which can trigger capital gains taxes earlier and at higher rates.

Index funds such as the Vanguard Index 500 fund typically have a very low turnover rate, about 5%. Their buy-and-hold methodology keeps turnover down and tends to defer capital gains taxes, at least as long as money keeps flowing into these funds. Significant net outflows, meaning sales of the fund greater than purchases, might force the fund to liquidate some of its holdings and thereby trigger capital gains taxes.

With a little more than 500 stocks in their portfolios, S&P 500 index funds have virtually eliminated company specific risk. Finally, Vanguard Index 500’s miniscule expense ratio of 19 basis points (0.19%) makes an actively managed fund like Smith Barney Appreciation C with an expense ratio of 177 basis points (1.77%) look greedy.

Market Inefficiency
So the U.S. large-company does not look promising for managers who want to “beat” the market. Are other markets less efficient, and do they therefore offer better opportunities for a stock-picker to shine?

Consider the market for U.S. small-capitalization companies. The thousands of publicly traded companies with market capitalizations below $750 million do not attract much institutional interest or analyst attention. Public information about these stocks does not get digested by the market as quickly.

I decided to compare the returns of the S&P 600 SmallCap index to the U.S. small capitalization equity funds in the Morningstar database. This little brother of the 500 index is made up of 600 smaller companies with a median capitalization of $528 million as of February 27, 1998, according to Standard & Poor’s.

The results confirm my hypothesis but also indicate that even the small-cap market may be becoming more efficient. For the three-year period ended February 28, 1998, the S&P 600 beat 70% of all domestic small cap funds. However, only 62% of funds trailed the index over the preceding five-year period. Even more striking, the index beat only 38% of the relevant funds in the Morningstar database during the trailing 10-year term.

These statistics indicate at least two possibilities. The first is that the index has recently improved its record against the funds by mere chance. The average for the three time periods was about 57%, not very convincing for the efficient-market proponents. The second possibility is that as more investors and analysts have followed the stock market over the last ten years, the S&P 600 index has improved its performance because all this attention is making the small-cap market more efficient. I think the latter is more likely, but I am not ready to take the next step and recommend buying index funds for small-stock investments. Not yet, anyway.

The Race
Quite honestly, it took a long time before I was convinced about the advantages of passive portfolio management versus active management for large-company stocks. Until recently, in fact, my entire IRA was invested in the American Express (IDS) New Dimensions A fund. This actively managed portfolio ran neck and neck with the Vanguard Index 500 during 1994-1996. At the beginning of 1997, as I was studying active versus passive portfolio management, I made a bet with myself. The best performer that year would keep or receive my entire IRA at the end of the year.

Well, Vanguard Index 500 won the race handily by almost a 9% margin. New Dimensions ended 1997 up 24.6%, but the Vanguard Index 500, the new home of the Jonathan M. Bergman IRA, rose 33.2%. Hey, if you can’t beat ’em, join ’em.

If you enjoyed this article, be sure to check out Palisades Hudson’s book, Looking Ahead: Life, Family, Wealth and Business After 55, now available in paperback and as an e-book.

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