Bylo rebuts: Investment Cafe • Week Of August 13, 2001
The Fund Library • Steve Kangas • Wednesday, August 15, 2001
Time to start bashing index funds!!

Comment: Time to start bashing index fund bashers. Sigh...

Apparently, the Investors Business Daily has lowered the rating on S&P500 index funds to a "D". "Even at the market lows in October 1990 and October 1998, S&P500 index funds' ratings sank to no lower than A-. And over the last three years, more than 60% of actively managed funds have bettered the index's record. That's the highest reading since 1994."

Rebuttal: This demonstrates what? That indexing doesn't work, or perhaps that the S&P 500 is neither the total stock market nor always the best-performing asset class? Or perhaps the enemies of indexing are so desperate to make a point that they'll dismiss a 25-year record of outperformance because of one "bad" year?

This is all interesting as we head to the 25th Anniversary of the Vanguard 500 Index Fund, which debuted on August 31, 1976. Not sure if the Vanguard folks will throw a party or not. Given the low MER, probably not.

In another commentary following up on the IBD article, Jerry Heaster of the Kansas City Star wrote the following:

August 07, 2001

"This month's 25th birthday of the index mutual fund comes at a time when the growth potential of the index investing concept is more open to question than at any time in the past decade. Investor's Business Daily noted in a recent "Investment Trends" column that its rating of Standard & Poor's 500 index funds has sunk to D. This is shocking, because even at the market lows of '90 and '98, the newspaper never rated these funds lower than A-.

The analysis said more than 60 percent of actively managed funds have outperformed the index's record during the past three years, raising a question of whether index investing is an idea whose time is past.

Rebuttal: Again, since when does the S&P 500 index represent "indexing?" What's shocking is that anyone, let alone IBD, would question the superiority of indexing based on a bad year or two. What's even more shocking is that anyone with a CFA designation would parrot this "proof" without challenge.

"Not by a long shot," the column declared, but there's no doubt the down-and-up history of index funds is struggling through a down phase.

Comment: Ah, so at least they're really not so sure after all.

During its first two decades, indexing went from a largely ignored part of the mutual fund mix to the industry's hottest product. When the then-fledgling Vanguard Group introduced its First Index Investment Trust for small investors in 1976, it hoped to attract $150 million. Its initial response, however, amounted to only $11.4 million, The Wall Street Journal recounted in a recent retrospective. Despite this inauspicious start, the historical perspective noted, it went on to become the behemoth Vanguard 500 Index Fund. The mutual fund tracking firm Lipper Inc. estimates that 12 percent of the money invested in diversified U.S. stock funds reposes in index portfolios. Among pension funds, it is estimated that indexing accounts for 25 percent to 30 percent of all assets, a remarkable development considering early efforts to sell the idea.

Rebuttal: And over that 25 year period, what percentage of US general equity funds beat the S&P 500?

Several years before Vanguard launched its index fund for individual investors, a money manager tried to sell a steel exec on indexing for his pension fund. When offered the alternative of matching the market instead of trying to outperform it, the executive said, "Sonny, I have never been average in my life, and I am not going to start now." Nevertheless, several indexing options came to market for institutional money managers, albeit with limited success.

Comment: So how did that steel exec's pension fund do in its quest to be better than merely average? The answer to this question might be more illuminating than the negative aspersions cast by this anecdote.

Nowadays, though, daring to be average is very much in vogue. The Wall Street Journal said all stock index investments when 2000 ended were estimated to have totaled $1.5 trillion.

Rebuttal: And the vast majority of that is institutional money. Are these money managers lazy or is it possible they know something that the proponents of active management don't (or at least don't want to acknowledge in public)?

Not that indexing was an overnight success. It was eight years before a second index fund was established. Moreover, explosive growth didn't happen until the mid-1990s, when the S&P 500 index's return began to substantially outpace most managed funds. As this trend continued, investors began their massive flight to index funds.

Rebuttal: A bad year or two is hardly new to indexing the S&P 500. Indeed during 5 of its first 10 years, as well as for the 3 year period from 1991 to 1993, Vanguard's S&P 500 index fund failed to outperform most US equity funds. Yet over the long term it has beaten the vast majority of actively-managed funds the vast majority of the time by a vast margin.

From What Can Active Managers Learn from Index Funds?, a speech by John Bogle delivered, ironically, in Toronto.

With the S&P 500 off about 20 percent from its March 2000 high, the bloom is off the indexing rose. Despite its D rating, however, Investor's Business Daily is optimistic about S&P 500 funds. Last quarter, it observed, fewer than one-third of the managed funds bested the S&P 500.

Comment: So why the emphasis on the first sentence but not on the next two?

The primary advantage of index funds, says Vanguard Group founder John Bogle, is that buying and holding a basket of stocks not only holds down a fund's annual operating expense, but also results in much lower tax bills for long-time fund investors. Index fund advocates believe the next 25 years will be even better than the first 25 as more investors come to understand these advantages." (emphasis was added by the Café editor!)

Comment: Now this is what really needs emphasizing.

Note Mr. Bogle's comments about buying and holding a basket of stocks...did you know that the supposedly passive S&P500 index has had 14 companies replaced in the first half of 2001? Or, that there were 58 changes in 2000 and 42 changes in 1999. Too, the most significant shift has been a move away from technology stocks. At the peak of the bubble, this sector represented one-third of the index. Today? Well, they are down to 17.5% of the index and are neck-and-neck with financial services for the largest piece of the pie.

1. After the bubble burst technology stocks dropped by about 50%. In a capitalization-weighted index one would therefore expect the weighting of technology stocks to automatically drop by about 50%, and 50% of one-third is -- surprise! -- about 17.5%. No need for the S&P 500 index committee to "move." Why they didn't even have to lift a finger.
2. Yes, the S&P index committee makes regular changes to the composition of the S&P 500 index. So do the sponsors of all other indexes. Yet the turnover that results from such changes is usually much lower -- about 10% per year in the case of the S&P 500 -- than the typical actively-managed fund which in the US turns over nearly 100% per year! Not only are most actively-managed funds unable to parlay this turnover into higher returns, but worse, their results are even lower after-tax.

In the same IBD article and that edition of the paper, they highlighted managers who HAVE beaten the index. And how do you think managers beat the index? By not replicating the index, that's how. Which, when you think about it, is exactly why you are paying higher fees. Do something, smart guy/gal, that I can't do myself. For example, Bill Miller of the Legg Mason Value Trust, who has beaten the S&P every year for the last decade. He has twice as much financial stocks than the index and has made outsized bets on retail and service stocks. Waste Management represents 7% of the fund, but only 0.17% of the index. Similarly, AOL Time Warner is 6.5% of the fund and only 1.9% of the index.

Rebuttal: No doubt some managers beat the S&P 500 over the past 10 years. What that steel company executive (and everyone else) wants to know today is not who did it over the past 10 years but rather what managers are going to beat the S&P 500 in the next 10 years. Sadly, the active-management "experts" are silent on this important issue.

Another highly rated/regarded manager is Richard Freeman of the Smith Barney Aggressive Growth Fund. He has nearly 3 times the index weight invested in health care stocks. His fund has beaten the S&P on average each of the last 10 years by 6.25 percentage points! Over the last five years, the margin was 16.5 percentage points.

Rebuttal: So how did this fund perform against a pure health care benchmark like the Dow Jones U.S. Healthcare Sector Index? Again, silence. And, of course, since few prudent investors would knowingly put most of their money in a single industry sector, what's the relevance that one manager out of literally thousands made a big bet and won big? How many others made big bets on other sectors and lost? Once more, silence. Hmmm...


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