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Joining the Index Is No Way to Beat It

Accepting indexlike performance without having indexlike costs is not a winning hand.

Heading South Friday's column showed how excess returns for the average diversified U.S. stock fund have slipped. Five years ago, the typical actively managed fund comfortably had beaten its benchmark index over the trailing 10 years before expenses, meaning that many also had done so even after paying their expenses.

Index funds had become the sales leaders because they were more transparent, simpler to understand, and delivered no surprises. But on performance alone, the actively managed funds could make a case for themselves.

No longer can they do so. Pre-cost excess returns* for large-company U.S. stock funds have disappeared in two out of three categories and have fallen below 1% in the third (large value). That makes two of the three large-company U.S.-stock categories losers to index funds after the payment of expenses, with the third a break-even proposition--but that break-even proposition carries greater uncertainty than do index funds and is less tax-efficient. Why bother?

*For details on this column’s calculations, see Friday’s column.

Two Peas, One Pod The problem that large-company U.S.-stock fund managers now face is that their funds, in aggregate, closely resemble the indexes.

As this century began, large-cap U.S.-stock funds differed substantially from the benchmarks. Huge growth companies--

The differences have completely, utterly disappeared. Compare

with those of the large-blend category average. They are essentially identical. The index fund has 19.4% of its assets in technology; the category average is 18.6%. The index fund has 14.1% in healthcare; the category average is 14.8%. The average price/earnings ratio for the stocks in the index fund is 18.8; the category average is 19.4. And so forth. The large-blend category, as a collective,

is

the S&P 500. It can’t win that way.

The same holds true for the other large-company U.S. stock fund categories, large growth and large value. They, too, are positioned similarly to the relevant Vanguard index funds. Thus, those categories won’t win unless their collective security selection adds more value than their expense ratios subtract. That is highly unlikely to occur. This portfolio manager prefers

(In a sense, this is an active share argument, modified so as to apply to categories. Active share contends that an individual fund can't beat an index without daring to be different at the security level. The same can be said for categories, with respect to factors such as asset allocations, industry allocations, and country weightings. If the major risk factors for a category and its benchmark are alike, so will be their pre-cost performances.)

Smaller Fry Matters don't improve greatly with small-company funds.

There is one exception: For reasons that remain unexplained (I first wrote about this puzzle 25 years ago!), actively managed small-value funds almost always defeat the indexes. That pattern has not changed. The green line on the chart below floats between +2 and +3 percentage points--a surplus large enough to overcome the burden of expense ratios.

The other two small-company categories, though, have been headed in the same direction as their large-company cousins. Excess returns have slid to the point where the categories can no longer overcome their costs, and the trend shows no indication of reversing.

Foreign Affairs The fate of overseas-stock funds is somewhat less clear. The relative-performance chart, shown below, loosely resembles those of the U.S.-stock funds. The active funds' returns were highest at the earliest time period and in recent years have settled into something approaching a steady state, with each foreign large-company stock category (blend, value, and growth) posting annualized gross excess returns of about 1 percentage point. However, their journey was less predictable than with the U.S.-stock funds. There were some bounces along the way.

(Note: The date intentionally reads 1998, as opposed to 1996 in the other charts. It reflects the availability of the data.)

The volatility owes to dissimilarities between the categories and their index alternatives. Consider foreign large-blend funds. Morningstar benchmarks that category against the MSCI ACWI ex USA Index (now there’s a cumbersome name if I’ve ever encountered one). They are not the same. The category has 17.2% of its assets in the United Kingdom, while the index is at 12.7%. Or, the category has about 18% of its assets in financial-services stocks, while the index is just over 23%. The disparities are such that, under unusual market conditions, the category’s performance can diverge substantially from that of the benchmark.

(Some would benchmark foreign large-blend funds against other indexes, for example MSCI EAFE or FTSE Global All Cap ex U.S.--the latter serving as the guide for

It is a similar tale for large-value and large-growth foreign-stock funds. Those categories don't look greatly different from the indexes against which they are compared, so that most years their performances will closely fall in line. However, unlike with the U.S. stock funds, there are a few gaps with sector and country allocations that could permit the foreign-stock categories a notable success. (Or, of course, a notable failure.) I don't judge that a particularly likely possibility, but it is a possibility.

On to Bonds Things look best for the major bond funds. The intermediate-term bond fund category (home of most of the big bond funds) and its customary benchmark, Barclays Capital U.S. Aggregate Bond Index, have headed their separate ways. The index is loaded with Treasuries. It has almost 40% of its assets in Treasuries, while the fund category has less than half, at 18%. Conversely, the funds have several times the index's weighting in commercial mortgages and asset-backed securities.

(Yes, the scalings for this column’s charts vary, such that the bond funds’ pre-cost victory margin looks substantial on the screen, but in reality it is smaller than those of small-company and foreign-stock funds. However, because bond funds have such narrow ranges of return, that level of outperformance is relatively larger than what the stock-fund categories have accomplished.)

Bond funds’ positioning arises from necessity. While active stock fund managers can convince themselves that their security-selection skills will overcome their funds’ expenses, high-grade bond fund managers enjoy no such luxury. They realize that they will get nowhere by mimicking the index’s safe, low-yielding Treasuries. They must differentiate their offerings. They must boost their funds’ yields by conceding liquidity, or accepting more credit risk, or increasing the portfolio’s duration. They must take their chances.

That is what gives active bond fund managers the best chance at competing with the index funds. It is not that they are brighter than stock fund managers or that their investment field holds greater rewards for insight. It is that they have opted to be different. Because they know that to act otherwise is to accept indexlike performance without having indexlike costs. And that is not a winning hand.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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