Passive vs. active investing --
Jeremy Siegel, a professor of finance at the Wharton
School of the University of Pennsylvania, dissected that amorphous
beast -- the stock market -- and uncovered some fascinating facts
that dispel common notions about investing. After studying the returns
of the individual companies that were part of the S&P 500 between
1957 and 2003, he reveals the following in his book, "The
Future for Investors."
- The more than 900 new firms that have been added to the index
since it was formulated in 1957 have, on average, underperformed
the original 500 firms in the index. Continually replenishing
the index with new, faster-growing firms while removing the
older, slower-growing firms has actually lowered the returns
to investors who link their returns to the S&P 500 Index.
- Long-term investors would have been better off had they bought
the original S&P 500 firms in 1957 and never bought any new
firms added to the index. By following this buy-and-never-sell
approach, investors would have outperformed almost all mutual
funds and money managers over the last half century.
The main reason for the lagging performance of the
new additions to the S&P 500, according to Siegel: Stock prices
of the added firms had been bid up to a level that precluded significant
future return potential.
As an example, he writes about the price appreciation
of Yahoo! between Nov. 30, 1999, when Standard & Poor's announced
its intention to add the Internet stock to the index, and Dec. 8,
when it was officially added. "In just five trading days, the stock
soared $68, or 64 percent above the price it was trading at before
the S&P announcement."
The same thing happened the following year to other
stocks between the time of Standard & Poor's announcement and their
actual inclusion to the index, notes Siegel, with King Pharmaceuticals
gaining 21 percent in the interim; CIT Group, 22 percent; JDS Uniphase,
27 percent; Medimmune, 31 percent and Broadvision, 50 percent.
Of course, that was part of that surreal era, when
any kind of good news impacted stock prices in an irrationally exuberant
way. Note, too, that technology became a more-significant industry
component of the benchmark just before the bear market hit, making
it more vulnerable to the ensuing downdraft.
Standard & Poor's has since taken steps to lessen
the impact of stock prices as they are added or deleted from the
index, Siegel notes. "Nevertheless, it is likely there will always
be a premium on S&P 500 stocks as long as the index retains its
popularity," he says.
Ditch the index?
In case you're wondering, Siegel doesn't bash indexing in his book.
A longtime proponent of the strategy, Siegel writes that the research
he conducted in recent years has altered his thinking. "Although
indexing will still provide good returns, there is a better way
to build wealth," he says.
Nevertheless, he ultimately advises investors to put
half of their equity holdings in U.S.- and foreign-stock index funds.
Around the edges, he suggests trying several "return-enhancing"
strategies that he reveals in his book -- an incredibly enthralling
read for stock-market devotees.
Even with all its shortcomings, the indexing strategy
has much to recommend it. You're almost guaranteed to get a superior
return to that of actively managed funds. Over the past decade,
Fidelity Spartan 500 Index and Vanguard 500 Index funds beat more
than 70 percent of their large-cap peers, according to Morningstar.
Most, though not all, index funds happen to be cheap,
which goes a long way to helping return. Fidelity recently reduced
the price of five index funds, including Spartan 500, to 0.10 percent
of assets -- nearly half what low-cost indexing giant Vanguard charges
investors, though Vanguard charges less (0.09 percent) to investors
with more than $100,000 in certain funds.
In addition, because many index funds have relatively
low portfolio turnover, they tend to be more tax-efficient than
the majority of their actively managed rivals, says Carlson.
So as a core strategy, indexing is the way to go,
regardless of whether you use exchange-traded
funds or index funds as your vehicle of choice.
As for implementing return-enhancing strategies around
the edges, you have several options. Go with active managers who
espouse investment styles you believe will work, get guidance from
a financial planner, or check out Siegel's book to read about the
strategies that worked best in the past. "There is no reason why
those strategies will not continue to serve investors well in our
future," Siegel concludes.
Longtime financial journalist Barbara
Mlotek Whelehan earned a certificate of specialization in financial
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