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Fund Indexers, Take (Another) Bow
December 4, 2005

It's worse than I thought.

Again and again in this column, I have argued that most stock-mutual-fund investors won't earn market-beating returns and that these folks would be better off buying market-tracking index funds. It turns out, however, that your chances of outpacing the stock-market averages are far slimmer than even I imagined.

What's the problem? Most performance-hungry investors don't own just one actively managed fund. Rather, they own a whole fistful of funds -- and with every fund they add, the odds against them grow steeper.

Lonely Quest

To gauge the chances of beating the market, I often look at the results of the Vanguard 500 Index Fund (VFINX), one of the country's largest funds, with $104 billion in assets. This year, the Vanguard fund has slightly underperformed its competitors in the "large blend" category. But over the past 10 years, it has beaten all but 23% of these competing funds, according to Chicago fund researcher Morningstar Inc.

There's a good reason index funds fare so well and actively managed funds perform so poorly. It starts with the brutal math of investing, which -- I regret -- is principally about subtraction.

Each year, the market delivers a raw return, and this return is then shared by investors. Some folks earn more than the market average. Most, however, earn less.

The blame lies with investment costs, such as annual fund expenses and trading costs. After these costs are subtracted from the market's raw return, investors collectively pocket less than the market average.

This is where index funds get their edge. By aiming to mimic a particular market index while incurring modest costs, an index fund is sure to outpace most actively managed funds that invest in the same market segment, because the results of these active funds are dragged down by their far heftier expenses.

As the record of Vanguard 500 suggests, an index fund will beat roughly three-quarters of comparable actively managed funds over any 10-year stretch. For market junkies, those don't seem like daunting odds. After all, with a little work, they should be able to make it into the top quarter, right?

That might be true if these market junkies were buying just one fund. Problem is, to build their desired portfolios, investors often purchase five, six or even a dozen funds.

Moreover, most of us are investing for a lot longer than 10 years. Figure in those two factors, and suddenly the odds of winning become almost insurmountable.

Fistful of Trouble

To understand why, consider some calculations by Allan Roth, a certified financial planner with Wealth Logic in Colorado Springs, Colo. Mr. Roth ran a "Monte Carlo" simulation comparing the results of two sets of portfolios, one that included index funds incurring total expenses equal to 0.25% of assets each year and the other consisting of actively managed funds that cost 2% annually.

To be sure, most actively managed funds have published annual expenses that are closer to 1.5%. But once you figure in trading costs, which aren't included in published expense ratios, the tab could easily hit 2%, especially if you own funds that invest in smaller stocks or foreign markets.

Mr. Roth's Monte Carlo simulation not only considers performance in a slew of market environments, both good and bad, but also takes into account the possibility that some actively managed funds will beat the market.

Result? Suppose the two sets of portfolios each consisted of just one fund. According to Mr. Roth's calculations, the chance that an actively managed fund will beat an index fund over one year is 43%.

Once again, those odds may not seem so bad. But as Mr. Roth notes, "the more funds you pick and the longer the time period, the worse the odds get." Indeed, with a single actively managed fund, the chances of beating an index fund shrink to 31% over five years, 25% over 10 years and 13% over 25 years.

Mr. Roth's model is right in line with what you would expect. Recall the results for the Vanguard 500 Index Fund, mentioned above. Just 23% of comparable large-company funds outperformed Vanguard 500 over the past 10 years.

But here's where it gets interesting. Suppose, instead, that the two sets of competing portfolios consist of five funds. Suddenly, the odds of an actively managed-fund portfolio beating an indexed portfolio shrink to 35% over one year, 18% over five years, 12% over 10 years and just 5% over 25 years.

As you add more funds, it gets even worse. Let's say you own 10 actively managed funds. Your chances of beating an indexed portfolio are 29% over one year, 11% over five years, 6% over 10 years and a scant 2% over 25 years.

It's like gambling in Las Vegas. Yes, you might get lucky on your first few bets. But the longer the night goes on and the more hands you play, the less likely you are to come out ahead. The reason: If you make enough bets in which the odds are against you, eventually mathematics is almost certain to triumph over luck.

Mr. Roth notes that his model considers only fund performance. He says the odds of beating an indexing strategy would look even worse if you figured in taxes and investors' bad timing.

"People get into the market at the wrong time, and they get out of the market at the wrong time, and they chase the hot funds," he notes. "The model doesn't build in human mistakes, beyond the mistake of buying higher-cost funds."

Admittedly, there are funds that beat the stock-market averages over long periods. But that doesn't mean it's easy to pick these winners in advance.

A classic example is Fidelity Magellan Fund (FMAGX), which -- at $51 billion in assets -- remains one of the country's largest mutual funds, despite being closed to new investors. Under legendary fund manager Peter Lynch, Magellan posted fabulous results in the late 1970s and throughout the 1980s.

That performance was great news for folks who already owned the fund. But it wasn't much of a buy signal. In fact, the fund has lagged behind the S&P 500 in seven of the past 10 calendar years.

As Mr. Roth puts it, investing in actively managed funds is "like smoking two packs a day and expecting to live to 100. It could happen. But you certainly aren't helping your odds."

Write to Jonathan Clements at

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