A recent piece in the Wall Street Journal reporting 75% of actively managed funds fell short of the S&P 500 in the second quarter has caused some stir among both index and active investors. Even CNBC rolled out some experts and hounded them about what this means for investors, and how to take advantage of it.
Because the S&P 500 is by far the most-watched index in the world, and also because you can invest in the index via inexpensive mutual funds and ETFs, investors sit up and take notice if it zooms ahead of the "average" actively managed mutual fund. Vanguard founder John Bogle for years he has pointed out that a sad majority of funds simply can't beat the index over time.
Ironically, however, the history of retail index investing, at least in the case of the S&P 500, has been the same as that of actively managed funds - that is, investors tend to chase returns right off the cliff of mean reversion. A Journal of Indexes article by Jim Wiandt looked at the 'assets chasing returns' trend for S&P 500 investing in detail.
In the 1990s there was an unprecedented bull market in large-cap stocks, and investors piled into S&P 500 index funds in record numbers. However, since the index is market-capitalization weighted, many investors probably didn't realize that a few stocks at the top were the main drivers of performance. As they went, the index went - and to be sure, they went up a lot.
To underscore this point, consider that at the end of the first quarter of 2004, about 22% of assets in Vanguard's S&P 500 index fund (ticker: VFINX) were stashed in the top ten stocks. In other words, nearly one-quarter of the fund's performance is driven by 2% of the stocks in the S&P 500. The S&P 500 is the giant of the indexing world with an estimated $1 trillion following it, but it would be interesting to find out how many small investors and advisors understand how concentrated the index is in the top names.
The "active vs. passive" debate is a tired one that seems to breed only more disinformation and misunderstandings. For example, many investors were undoubtedly lured into S&P 500 index funds at the wrong time in the late 1990s, when they could no longer bear that their mutual funds were lagging the index.
There's nothing wrong with S&P 500 index funds - they're a perfectly reasonable choice to cover large-cap equities, especially if one doesn't want to shop around for large-cap managers. Many investors use S&P 500 index funds for large-cap exposure to free up time to search for quality small- and mid-cap managers (or to fill in with mid and small cap index-based funds) - the so-called 'core and explore' approach. However, in the end, it's the asset allocation that matters most.
Whether it's a bear or bull market, or whether large-caps beat small-caps, one thing remains constant - investors are misled by S&P 500 comparisons against ALL mutual funds. A more useful exercise is to compare apples to apples - large-cap blend funds to the S&P 500, small-cap funds to a more appropriate benchmark like the Russell 2000, for example.
Year to date, the S&P 500 is up only 1.10%, but according to Morningstar that's good enough to beat 70% of its large-cap peers, as noted in the Journal article. However, 7 months is too little time on which to base any real active vs. passive conclusions, since the results can be biased due to many factors - for example how smaller companies are doing, and how much cash managers are holding in their portfolios.
Although S&P hasn't released its data for its second quarter Standard & Poor's Indices Versus Active Funds Scorecard (SPIVA), the long-term performance comparisons from the first quarter give the nod to the indexes in every market segment.
"Indices are still the winners over the long term," reported S&P at the end of Q1 2004. "Over the last five years [for the period ending Q1 2004] the S&P 500 has outperformed 52.3% of large-cap funds, the S&P MidCap 400 outperformed 86.2% of mid-cap funds and the S&P Small Cap 600 has outperformed 72.7% of small-cap funds."
S&P also throws another wrinkle in by calculating asset-weighted returns, which paint an even bleaker picture. The predictable result - investors chase asset classes, to their detriment.
The refreshing thing about the ongoing S&P report is that funds are compared against the relevant index. The S&P 500 isn't compared against the "average" mutual fund (there are thousands), which only serves to confuse investors. It's interesting to note that the S&P 500 has fared the worst against mutual funds, among the capitalization indexes, over the past five years.
But now in 2004, and especially in the second quarter, the S&P 500 is beating large-cap managers. But investors should ignore the hype and resist going full bore into the index. Hopefully they'll learn from the lessons of the late 1990s. S&P index funds are a nice choice for large-caps if used with a balance of other asset classes.
John Spence is editor of IndexUniverse.com. Check out his musings on the ETF industry each Monday at CBSMarketWatch.com. If you have ETF story ideas, contact him at [email protected]. Also contact him if you have an article submission for The Journal of Indexes -- or if you're a financial reporter wishing to interview Steven Schoenfeld on his upcoming book Active Index Investing.