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Passive vs. active investing -- Page 2

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.
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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 planning.

If you have a comment or suggestion about this column, write to Boomer Bucks. If you have a particular financial problem that you would like addressed, please send your queries to Dr. Don, Tax Talk, the Real Estate Adviser or the Debt Adviser.

-- Posted: July 13, 2005




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