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Tuesday, January 4, 2011

Index Funds-Mediocre Performance?

Many investors go the active management route because they believe indexing produces mediocre results. After all, in any period it is obvious that there are active funds, sectors, market timers, etc., that beat the market and beat the market by a lot. That will be true as well for 2010.

It follows, then, that the reward is huge for those who are able to beat the market or pick those who will beat the market - in the short run. If the investment strategy outperforms by 9%, it doesn't matter if fees and hidden costs are huge.

In my former life, I was an institutional investment manager. ,I managed funds for some of the largest pension funds in the country. Performance results were a big deal. Rankings with other managers who were competing for business were compiled, scrutinized and were a primary factor in gaining or losing business. The objective was to get performance in the upper quartile - the top 25%.

Quartile rankings were done for various periods: 1-year, 3-year, 5-year, 10-year, etc. As time went by, I noticed something interesting. We went through a period where we were consistently in the 2nd quartile - respectable, but not hitting the ball in the upper deck. What I noticed was that consistent 2nd quartile performance in the short run pushed us into the upper quartile over the long run.

Being in the second quartile meant you never went into a meeting and said we were number 18 out of a 100 managers for the last quarter or last year. Instead, you were more like number 38 or 42, etc. But for the longer term, the 5-year or 10-year results, you were able to say, in fact, we were number 18 or 15 out of 100.

How could this be? Studying the rankings over the long term, I found that many managers in the top quartile over the short term took risks or used a style that went out of favor in subsequent periods. They took positions and structured their portfolio radically different from the indices they were seeking to outperform. In some periods, they were very aggressive in timing the market. They went out of favor to such an extent that they performed in the bottom quartile - they went from hero to goat. Over the longer term, many ended up in the 3rd quartile.

For individuals, as well as for pension funds, the most important performance is over the longer term. Most individuals will be investing 35 - 40 years. By investing in low cost index funds, diversifying appropriately, and rebalancing according to a well-thought-out asset allocation, results will be in the second quartile ranking over most short-term periods. Over the longer term, this will have the best chance of reaching the top quartile where they want to be.


  1. I've been in several non-index funds that have beaten the indexes over 10 and 15 year periods with less risk. What is more difficult to figure out is if they have beaten the indexes on an after-tax basis. I've gotten hit with some pretty good capital gains distributions over the years. Bogle cites one of the in The Little Book of Common Sense Investing as having beaten the index. But the future is always uncertain and management has changed, though the investment philosophy is still the same. My new money is going into a balanced portfolio of indexes because I am tired of having no control over when these capital gains distributions take place.

  2. If you've beaten the market overall you are ahead of the game at least in your qualified accounts.
    If we take 10 stocks, 2 are going to be home runs, 2 will be duds, and 6 will more or less match the market. Sometimes people say look I picked stocks that beat the market but overall results were pretty much in line with the market.
    From reading your blog I would think your best shot at beating the market would be picking individual stocks and avoiding all costs except the cost of doing the research.

  3. Noo... my comment got eaten. In any case, market returns are not too shabby over the long haul, though I wonder about the effect of people continuing to pile into passive index funds.

  4. You are exactly right ... they aren't shabby. I wouldn't worry about people piling in. The industry of convincing people that they can beat the market is huge and therefore resources will continue to be directed towards getting people to pick stocks etc.
    The good news I think is that fees will continue to drop and more active managers will outperform.