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Reading the Evidence on Indexing

In some situations, passive investing strategies should not be an automatic choice, even for advocates of indexing, says Morningstar's John Rekenthaler.

John Rekenthaler, 11/30/2011

There’s no disputing the basic argument for indexing: Dull short-term results eventually lead to sparkling long-term figures. What’s less clear, however, is if and when there are exceptions to the rule. Are there fund categories in which indexing fails? Such discussions tend to be varied—which is not a good thing because many different answers do not mean many different realities. This means, instead, that most observers are wrong.

For example, consider the recent and common claim that domestic fund managers have been badly beaten by index funds during the past three years because U.S. stocks have become more highly correlated. This statement bundles three propositions: Active domestic funds are performing particularly poorly relative to indexes; U.S. stocks are trading more as a block; and a high correlation in stocks confounds the efforts of active managers.

The third proposition would be difficult to prove, but the claim fails on the initial premise. It is true that the average diversified U.S.-stock fund has lagged the no-cost Morningstar U.S. Stock Market Index by 67 basis points per year over the trailing three years (through Sept. 30, 2011), but it leads that same index by 77 basis points annually over the trailing decade. So, by that measure, yes, funds are faring worse than usual.

However, this analysis is inadequate because the index is capitalization-weighted, while the mutual fund average is equal-weighted. This is a problem as the mutual fund average incorporates a style effect, tilting toward smaller companies.

Adjust the study so that it compares fund averages for each of the nine Morningstar Style Box categories against their nine style indexes, and the story changes. Now, the funds lag by 118 basis points for three years and 49 basis points for 10 years—not a great difference. Given that survivorship bias boosts the funds over the longer time period, the claim disappears entirely.

In this article, I’ll address two common difficulties when analyzing the performance of active versus passive management—benchmark fallacy and benchmark choice. I’ll then suggest a better way of thinking about where indexing might fail.

Case Study: Vanguard Intermediate-Term
Bond Index

On Aug. 11, Morningstar’s Christine Benz noticed something quite peculiar—the single-best-performing intermediate-bond fund over the trailing month, out of 1,238 funds in the category, was Vanguard Intermediate- Term Bond Index VBIIX.

Not exactly The House That Jack Built. Certainly there are performance variations, and index funds wouldn’t be expected to place in the 45th percentile each and every month. But landing in top thousandth? After one month? What in the name of Bogle had happened?

is vice president of research for Morningstar.

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