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Fiduciary Focus: Active vs. Passive Investing (Part 6)

We dispel more myths about passive and active investing.

W. Scott Simon, 07/29/2005

This month's column, which continues to dispel some widely accepted myths of passive investing, will be the last in my seven-part series on active investing and passive investing in the context of modern prudent fiduciary investing.

Myth: S&P 500 Index Funds create a self-fulfilling prophecy that drives up the value of the S&P 500.

The inflow of money to S&P 500 index funds in the 1990s drove up the prices of S&P 500 stocks, which, in a "self-fulfilling prophecy" of success, generated even more investment in S&P 500 index funds. This is what caused S&P 500 index funds to outperform most active mutual funds.

Reality: There are at least five reasons why S&P 500 index funds were not the cause of the tremendous advance of the S&P 500 over the period of 1995-99.

1. There was a net outflow of all money indexed to the S&P 500.

Institutional investors such as pension funds and separate accounts of individual stocks invest about 80% of all money indexed to the S&P 500. Non-institutional investors in S&P 500 index mutual funds that are sold directly to the public (i.e., "retail" funds) account for the rest. As institutional investors moved money into broader indexes such as the Wilshire 5000, they withdrew more money (over $100 billion) from funds indexed to the S&P 500 than had been invested by investors in retail S&P 500 index funds. There was a net outflow, then, of all money indexed to the S&P 500 for each of the five years during 1995-99.

This fact is little known because the financial media report cash flows for only retail S&P 500 index funds open to non-institutional investors--which did show a net inflow of money. The media thus presented only part of the picture, while representing it as the whole picture. Since there was a net outflow of money from all funds indexed to the S&P 500 for each of the five years during 1995-99, money indexed to the S&P 500 didn't cause the run-up in value of that index.

2. Money invested in passive stock funds comprises about 8% of money invested in all stock mutual funds.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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