Sunday Musings: Index Funds Vs. Mutual Funds

Every so often a new study surfaces, which promotes the virtues of index investing vs. the use of “old fashioned” mutual funds. Here’s the latest titled “Cast your fortunes with index funds.” Let’s listen in:

Investors who continue to send money to actively managed mutual funds in the hope that managers will be able to beat less-costly index funds are going to lose out almost all of the time, a new study finds.

The study by two noted finance professors claims that it’s effectively impossible to tell whether a manager has performed well due to luck or skill — which means that it’s also impossible for an investor to know for sure.

In other words, stop trying to pick market-beating managers — instead, choose index-linked funds.

Fama and Kenneth French, professor of finance at Dartmouth College Tuck School of Business, ran 10,000 simulations of what investors could expect from actively managed funds. They found that outside the top 3% of funds, active management lags results that would be delivered due simply to chance.

Fama and French’s study, “Luck Versus Skill in the Cross Section of Mutual Fund Returns,” looked at the returns of 3,156 U.S. stock mutual funds from January 1984 to September 2006. It included mutual funds that were liquidated and any fund launched before September 2001 that reached more than $5 million in assets. Find a copy of the report at the Social Science Research Network.

The fact that some funds beat the simulations does suggest that by picking the right funds investors can consistently outperform the market. But there’s just one problem, according to the professors: “[T]he good funds are indistinguishable from the lucky bad funds that land in the top percentiles.”

That leaves picking the right fund a matter of guesswork. So even if investors stick with the top performers, they’re running a risk because the manager’s good results could be based on luck.

“You’re taking the chance of being with somebody’s who’s not just lucky, but actually bad,” added Fama.

The presence of both good funds and lucky bad funds means it’s likely that investors focused on top performers will end up with returns close to the market.

“In other words, going forward we expect that a portfolio of low-cost index funds will perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe,” wrote the professors.

Although it is not specifically mentioned, the entire study is based on buy and hold investing. If that were my mode of operation, sure, I might decide on low cost index funds as well.

Personally, I think making the case of a bad fund manager being lucky is just being plain silly. A “good” fund manager may have been able to pick better stocks in a bull market than a “bad” fund manager, but when a bear market strikes, just as we’ve seen in 2000 and 20008, both will lose money at an alarming rate.

The point that is overlooked in this study is that all equity funds (unless they’re bear market funds) and indexes are geared to work only in a bullish environment, and all will fail miserably at varying degrees in down markets.

I believe that both, mutual funds and ETFs, should be selected based on which might be most appropriate at the time an investment is made. A quick check of my data base M-Index rankings revealed that currently 29 no load mutual funds rank higher than 13 on the scale, while only 12 ETFs of the same orientation qualified.

Rather than trying to continue with study after study to try to come up with results that favor indexes over mutual funds, the case should be made for using an investment approach that keeps investors out of bear markets and invested only when the trend is bullish. It would avoid a lot of heartaches and end the discussion as to whether index funds are superior to mutual funds.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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