On one hand, we have brokers, or salespeople, who sell financial products designed to put the most money in the hands of the people who manage and sell said products. On the other hand, we have financial advisors who swear that for long-term investing, index funds will provide the best and safest return. The brokers say their products beat the “average” returns provided by index funds that follow the market while index fund proponents say most managed funds won’t consistently beat the market’s return.
So who is right? Tim Middleton from MSN Money has an opinion about the issue. We’ve been tricked to believe index funds represent the market.
If you’ve been tricked into thinking an S&P 500 index fund is a one-stop solution to your portfolio planning, it’s understandable. Thanks to relentless promotion from Standard & Poor’s and Vanguard, the 500, in the minds of investors, “represents the market…” If your life’s goal is a gentleman’s C, indexing was invented for you. But if you think you’re as smart as Lisa Simpson, who gets A’s, you’ll find it takes very little homework to earn them.
Middleton’s article compares performance (to a maximum of the last 5 years) between index funds and above average and “really good” mutual funds. Later on in the article, the author says something very interesting.
It is true that over long periods, popular indexes and group averages converge. That’s not surprising: Most fund managers’ pay is linked directly to a benchmark. If their clients include pension funds and insurance companies, which value conventional investment wisdom above everything, they can be fired for doing too well.
Mutual fund managers purposefully seek lower returns to keep their jobs safe? That is a strange concept to me. Middleton provides some names of managers who have consistently beaten their related index funds over the long term. But using the author’s own logic, how can you invest with managers who have beaten the average? Middleton admits that superior performance will eventually return to the average. In order to converge, funds returning superior performance would have to provide lackluster performance while the “average” fund continues providing average returns.
By the time you determine who the star managers are, it’s likely too late to invest with them. Eventually, their performance will converge with the index funds.
Can you pick star managers before the rest of the world? That’s the only way you can easily make a lot of money with managed mutual funds. In order to pick star managers, you’re going to need information that the rest of the investing world doesn’t have, according to the efficient market hypothesis.
Can you spot a Warren Buffett, Bill Miller, Bill Gross, or Bob Rodriguez before everyone else can?
Think of it this way. Most likely, you missed out on Microsoft‘s total return of 2,784% from March 28, 1986 to March 20, 1992 (six years). More likely, you’ve seen something similar to a total return of 1,004% from March 20, 1992 to March 6, 2007 (fifteen years). Google lets me compare MSFT with the S&P index over the last six years and in this period of time, the index returned above 10% while MSFT returned less than -10%.
Buying Microsoft after its first periods of superior returns is like buying a manager who has already seen his or her best years. All that’s left is to return to the average.
Published or updated March 7, 2007.