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A Surprising Look at Indexing and the Average Investor

Our study finds that investors outperformed the average fund, but not its index.

Russel Kinnel, 03/27/2006

In 2005, fewer than 25% of small-cap U.S. stock funds beat their respective Morningstar Index. Meanwhile, more than 75% of large-cap U.S. stock funds beat their respective index. Conclusion: The small-cap market is much more efficient than large caps, so investors should index small caps and choose an active manager for large caps.

Okay, I'm being facetious. But I'm amazed at how readily investment professionals, reporters, and individual investors reach the opposite conclusion when the data show small-cap funds beating their indexes and large caps losing.

Much of the reporting on active versus passive strategies does more harm than good. The biggest problem is that reporters sometimes use the S&P 500 as a proxy for indexing and measure all funds against it. But if you're comparing small- and mid-cap funds with the large-company-dominated S&P 500, you're really comparing market capitalization ranges--not measuring passive investing against active.

The second problem is that when they do include a small-cap index as a benchmark, fund companies and reporters alike use the Russell 2000, which is the index equivalent of the Washington Generals. (That's the team the Harlem Globetrotters always beat.) The Russell 2000 has been an easy mark because it rebalances only once a year, and hedge funds and institutional investors can buy names going in and short those leaving, thus driving down the performance of the index. Consider that from May 1992 through January 2006, the Russell 2000's annualized returns of 11.6% were easily eclipsed by the Dow Jones Wilshire Small Cap 1750 Index's returns of 12.72%, the S&P Small Cap 600 Index's returns of 13.81%, and DFA U.S. Small Cap's DFSTX 13.47%. DFA is a mutual fund with expenses and trading costs, yet it was still 1.87 percentage points per year ahead of the Russell index. In short, the Russell 2000 can be easily beaten by other index funds, let alone actively managed funds. Russell maintains it would be too costly for funds that track its index if it reconstituted the index more often, but, for whatever reason, its small-cap index lags funds and other indexes alike.

Digging into the Numbers

To get a fresh perspective, I compared the average fund returns over the past nine years by category with those of the nine Morningstar Indexes based on stock style. In addition, I looked at the asset-weighted returns by category to get a sense of what the average investor earned. That means we count the returns of a $5 billion fund five times more than a $1 billion fund in figuring overall returns for a category.

I chose the Morningstar Indexes because they are built using the same underlying methodology as our style box, and thus sync up well with the funds in each category.

However, there are two key differences between the indexes and mutual funds. First, the indexes are essentially pure plays on their slice of the style box, whereas mutual funds generally spread their investments around across a wide area so that they have a good chunk of assets in two or three of the nine boxes. There's nothing wrong with that--I don't believe in straitjackets for active managers--but it does go a long way toward explaining shorter-term performance for any one category.

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