A random walk in the financial park …

I’ve looked high and low and I’ve finally found it!

‘It’ is the source document for all of the commentators who have (rightly) suggested that Index Funds outperform actively managed Mutual Funds.

And, it is produced by Standard & Poors who publish the major Indices themselves:

The Standard & Poor’s Index Versus Active (SPIVA) methodology is designed to provide an accurate and objective apples-to-apples comparison of funds’ performance versus their appropriate style indices, correcting for factors that have skewed results in previous index-versus-active analyses in the industry.

And, here are their most recent findings (they are in the process of rebuilding their databases for 2008):

Indices continue to exceed a majority of active funds. Over the past three years (and five years), the S&P 500 has beaten 65.7%   (72.2%) of large-cap funds, the S&P MidCap 400 has outperformed 68.6% (77.4%) of mid-cap funds, and the S&P SmallCap 600 has outpaced 80.2% (77.7%) of small-cap funds.

The solution is simple: don’t buy any of the funds in the bottom 65.7% 🙂

Great! But how?

Well, Mutual Funds are rated by Morningstar as 5-Star (best performance) to 1-Star (worst performance) so, we should simply buy 5-Star funds, right?

Wrong … because Morningstar – even though it is the best / most highly regarded of all the Mutual Fund ratings services – is only based upon past performance, which is NO guide to how any rated fund will perform in the future as this independent research review found:

They find, for example, that five-star US equity funds significantly outperform one-star funds only 37.5% of the time; at the same time, these same funds significantly outperform three star-funds 18.75% of the time. It is clear then that—compared to a random walk–Morningstar’s ratings system offers no added value in terms of predicting mutual fund returns.

If the best can’t do it, do you think you can?

And, do you want to leave your financial future to a ‘random walk’ in the financial park?!

So, why do funds tend to fall short of the ‘market’?

Well, partly because of a tendency to trade stocks too much (the fund managers like to ‘look busy’) and partly because of fees … Mutual Funds tend to fall short of the market by the amount of the fees that they charge!

The ‘small moral’ of the story: invest in the Indices …

… find a low cost Index Fund that will do the job; by as much of it as you want and hold it for the long term.

Of course, the ‘large moral’ of the story is: who the hell is content with 11.9% maximum long-term stock market index returns, anyway 😉

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8 thoughts on “A random walk in the financial park …

  1. If the average is better than 70% of funds, it doesn’t bode well for picking the “right” fund(s). Is there any reason to believe you, I or anyone else could consistantly pick the winning funds?

    -Rick Francis

  2. Nice post! This study takes into account many factors–survivorship bias, wieghting, style, etc–that typically skew other similar reports.

    11.9% annualized RoR can get you where you want to go, it will just take you longer…

  3. @ Jeff – To me “where you want to go” implies BOTH a Number ($ amount) AND a Date. For many of my readers, that seems to imply compound growth rates far in excess of 11.9%. But, it is certainly a lot better than 3.9% 🙂

  4. AJC,

    The statistic you quoted make pure change a bad bet- you would only pick a winning fund ~30% of the time. So, to beat chance you have to have some system that you get the right fund. Do you have a system to pick winning funds? If so, what is it? How long have you tested it and what is your record of success? I believe such a system could potentially exist, but I haven’t seen evidence of one. If it was easy wouldn’t a company have offered a mutual fund that usually picks the winning funds each year and deliver returns that consistently beat the market?

    -Rick Francis

  5. @ Rick – The conclusion that I draw is that there can be no such system else we would already all be using it. Therefore, I simply steer-clear of mutual funds. What do I do instead?

    As with most things stock-related, I turn to the expert, Warren Buffett:

    1. If you DO know what you’re doing: hand-pick a handful of individual stocks

    2. If you know DON’T what you’re doing: buy a low cost (e.g. Vanguard or Fidelity) Index Fund.

  6. @ Kiwi – Thanks! For you, I should change the name of my blog to Sux Million in Sux Years :)) Only 1% of my readers will understand this 😉

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