Why index funds beat active strategies

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Spotlight: Michael Buek

When you invest, should you put money in a cheap, passively managed index fund that simply mirrors a particular benchmark? Or is it better to place a bet in an actively managed fund that attempts to beat the market?

Proponents of both types of investing have argued about this for years. Bankrate checked the Standard & Poor’s Indices Versus Active Funds Score card to review recent results. Generally, over most rolling five-year calendar periods, the indexers win.

For example, over the five-year period ending in December 2008, the S&P 500 outperformed 72 percent of its active large-cap competitors; the S&P 400 MidCap index beat 79 percent of active mid-cap funds; and the S&P SmallCap 600 pummeled nearly 86 percent of active small-cap funds.

The tally at midyear 2009 was more mixed. The report says the latest data for stock funds can be interpreted favorably by active and passive investors, depending on whether they look at equal-weighted averages or asset-weighted returns.

Nevertheless, we wanted to find out why the odds are so much better for investors who employ an indexing strategy. Who better to ask than the index fund king at Vanguard, the firm famous for its offerings of low-cost index funds.

An occasional marathon competitor, Michael Buek has been running Vanguard’s index funds since April 2005, and he also helps run Vanguard’s actively managed quantitative funds. He took time out of his hectic schedule to share his perspective about the indexing strategy.

At a glance
Name: Michael Buek, CFA
Hometown: Kennett Square, Pa.
Education: B.S., University of Vermont; M.B.A., Villanova University
Career highlights:
  • A principal in Vanguard Quantitative Equity Group.
  • Joined Vanguard in 1987; has been on the trading desk since 1991.
  • Performs the trading function for the Quantitative Equity Group.
  • Earned a CFA certification in 1998.

Why is the S&P 500 so hard for large-cap money managers to beat?

I would say that it comes down to two primary factors — costs and market efficiency. The case for indexing is based in the belief that before costs, the market is a zero-sum game. For every stock trade, there is a buy and a sell, representing a winner and a loser. For every investor that outperforms the market, another investor has to underperform. In aggregate, investors are unable to beat the market because they are the market — half of investors will win, half will lose.

However, when investment costs are factored in, the average investor no longer earns the market rate of return. Those average returns are significantly eroded by costs. For example, if an investment manager charges 2 percent a year to run a fund, he or she has to consistently outperform the index by 2 percent just to match the market’s return. And that management expense doesn’t include additional transaction costs required to buy and sell securities, which can be quite high, as active managers typically have higher turnover of names in their portfolios. Therefore, investors who own the entire market at a very low cost should outperform most active managers over the long run.

Second, markets are very efficient and hard to beat. There are thousands of skilled professionals trying to buy and sell stocks and add value, and most information is already reflected in a stock’s current price. It is very difficult to find a manager that has the skill to consistently — and over long periods of time — buy the right securities at the right time, and sell them at just the right time. We don’t live in Lake Wobegon where all investment managers are above average. Very few managers have outperformed the markets consistently.

“Even the mighty can fall, as we’ve seen all too clearly this year. Markets are dynamic, and market leaders do indeed change, sometimes, quite rapidly.”

Could one reason the indexing strategy outperforms be that once a company lands on the S&P list, it’s automatically in huge demand by index funds?

Not really. Generally, S&P preannounces index additions. In the days leading up to the stock’s official addition to the index, active managers have the opportunity to buy the stock, and there are far more active managers than index managers. S&P 500 index funds only make up about 10 percent of the U.S. investment market. Many active managers that use the S&P as a benchmark prefer to have exposure to all or most of the stocks in the S&P. If Microsoft is 2 percent of the index, they may match the index with a 2 percent weight in their portfolio, or based on their research, may own less or more. In this way, they don’t risk potentially omitting a strong-performing stock altogether, but they can limit or increase their exposure based on their convictions.

Indexing is supposed to be a passive strategy, yet companies come and go from the S&P 500. Nearly 40 companies fell off the list in the year through August, and 100 were replaced over the past three years. Why so many changes in an index that’s supposed to represent the biggest and best in America?

Even the mighty can fall, as we’ve seen all too clearly this year. Markets are dynamic, and market leaders do indeed change, sometimes, quite rapidly. The advantage of holding a very broadly diversified portfolio, like the S&P 500, is that no company typically makes up more than a few percentage points of your overall portfolio. If you own an individual portfolio of 20 or 30 stocks and one fails, it represents a much more significant hit to your bottom line than if your portfolio has hundreds or thousands of names. Of course, the reverse is true on the upside.

I will note that the S&P 500 only measures the largest companies in the country, and we typically recommend that investors own the entire market. For example, the MSCI U.S. Broad Market Index covers more than 3,000 large, medium and small companies, so as companies grow and shrink, they will continue to be represented in that index, just in varying proportions.

What criteria does Standard & Poor’s use to pick the companies that end up on the S&P 500 list?

Generally, index members must be U.S. companies that have a minimum market capitalization of $3 billion, and 50 percent of their shares must be available for purchase by investors. This is called public float. Corporate actions, such as mergers or acquisitions, can impact whether a stock is included or excluded from the index. Unlike many other indexes that are entirely “rules-based,” the S&P 500 is maintained by a committee of eight members of Standard & Poor’s staff that makes the ultimate determination of which companies are included or excluded from the index.

At what point do companies get thrown off the index and why?

Generally, companies that are involved in mergers or acquisitions or significant restructuring may be removed, or those that shrink below $3 billion. Companies that don’t have adequate liquidity or are financially unstable may be removed, or a company that moves overseas may be excluded.

When Standard & Poor’s announces a change in the index that is scheduled in the near future, do you begin buying the stock immediately? Or do you have to refrain until the date when the company is actually added to the index?

There is no requirement around how an index fund manages index changes. Our goal is to match the performance of the index as closely as possible and mitigate transaction costs.

Do you actually own all 500 companies in the fund? If not, how many do you own, and what else do you own?

Yes, we own all 500. If an investor looks at our Web site, Vanguard.com, they may see more than 500 listed under the portfolio holdings summary, but this is a technical issue. Some companies offer A shares and B shares, and when we buy them they are listed as two separate holdings, even though they represent the stock of a single company.

Do you own S&P futures or options? If so, please explain in lay terms exactly what these contracts are.

We do own S&P futures contracts. Readers are probably familiar with futures from early-morning radio reports that monitor futures prices to indicate whether the markets will open higher or lower for the day. S&P 500 futures are a contract between a buyer and a seller to buy the stocks of the S&P 500 at a certain price, on a certain date in the future. Since the contract is a “promise” to buy the underlying stocks, only a small amount of collateral is required upfront, rather than the full dollar amount required to buy all 500 stocks. If the S&P 500 index moves higher or lower, the prices of S&P futures contracts move in lock step. Futures are very liquid, so mutual funds use futures to put incoming cash to work in the markets, and that cash will earn a similar rate of return as the stocks of the S&P 500. Likewise, to meet investor redemptions, it can be more efficient to sell futures than actual S&P 500 stocks.

Why is the S&P weighted by market cap rather than having equal representation of each company?

We believe that market-cap weighted indexes are the “right” way to index. Indexes should reflect the market that they are intended to measure, whether it is large-cap, small-cap or some other market segment. The best index is the one that most accurately measures the performance of that market. The appropriate construction of indexes is therefore weighted according to what investors own, or, market capitalization. Simply put, market-cap-weighted indexes measure the returns investors, collectively, could potentially earn from the broad market or segment of the market.

That means the biggest companies have the most influence over the index’s performance, right?

Yes, but in a broadly diversified index, the overall influence of any one company is relatively small.

Is that another factor that makes the S&P 500 so hard to beat?

Perhaps, but again, the benchmark is tough to beat because the average active manager is his own worst enemy. High costs inherent in an active strategy represent a tremendous headwind to overcome.

What’s your philosophy of active vs. passive management? Do you personally own only passive index funds?

Yes, all of my investments are in Vanguard index funds. That said, many people don’t realize that Vanguard’s earliest funds were actively managed funds, and even today about half of our investors’ assets are in actively managed funds. We believe that the ultimate decision isn’t between index or active, it’s between low-cost or high-cost. For most investors, index funds are an easy, low-cost way to get broadly diversified exposure and can serve as the core of an investment portfolio. But there can be some managers that outperform the benchmarks over time. Active funds can play a supporting role in a portfolio, if you can select a well-managed, low-cost active fund.

Is there an investment strategy out there that you consider superior to indexing?

I’m a bit biased, but no.

What do you think about enhanced index funds?

Despite their name, enhanced index funds aren’t index funds at all. They’re actively managed quantitative funds, and typically higher cost than plain-vanilla index funds. Index funds are designed to measure the returns that investors in aggregate receive in a particular market — the returns of all investors in large companies, or all investors in China, for example. Enhanced index funds don’t do that. Instead they take an index, and include or exclude stocks with specific characteristics or “factors,” with the goal of beating an index like the S&P 500. There’s nothing inherently wrong with this type of quantitative investing, and in fact, Vanguard runs several actively managed quant funds. But, we’re all for truth in labeling.