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Which Way to Wealth?

Stock funds that try to beat the market indexes usually don't. Investor's frenetic search for hot funds this year thus begs the question: Is it worth it?


Most mutual fund investors know the drill. As you're signing away those first dollars to a fund you've just chosen, two fingers on your other hand are crossed.

How can you be sure you haven't picked a loser? At the very least, how do you know that your fund will perform better, over time, than the stock market average--the minimum return you deserve?

The short answer, of course, is you can't know. And as hundreds of thousands of new investors have jumped into stock funds over the last 18 months, handing record sums to fund managers, concern about relative performance has been rather muted: The market overall has been such a wild party that few fund owners could reasonably claim disappointment.

Last year, the average general U.S. stock fund soared 31.1%. In the first six months of this year, despite the market's pullback in recent weeks, the average fund gained 10.7%, according to preliminary data from fund tracker Lipper Analytical Services.

But how good were those results, really? For all the work and worry that many investors put into picking and monitoring stock funds from within the 3,500-fund equity universe, a far simpler, nearly effortless investment strategy would have served them quite well last year and this year: Just "buying the market," as represented by the blue-chip Standard & Poor's 500-stock index.

The S&P, the most popular broad measure of U.S. market performance, soared 37.5% in 1995, or 6.4 percentage points more than the average stock fund.

So far this year, the S&P has risen about 10%, counting reinvested dividends. Compared with the average stock fund return of 10.7%, the S&P return was arguably achieved with a lot less risk than the average fund manager endured in producing only a slightly higher return.

The latest hot streak for the S&P, and for the mutual funds that now invest solely in those stocks as a way of approximating the index's returns, has resurrected an old debate that veteran investors know well but often ignore and that newer investors may not yet appreciate.

That debate: Is "active" investing--what most fund managers are paid handsomely to do--worth the cost, trouble and risk, versus simply owning a "passive" portfolio that represents the market as a whole?

Passive, or index, investing in the S&P gives you a stake in the biggest companies in America, from Exxon to Philip Morris to Sears. They are not, typically, the fastest-growing companies, but they are the businesses that have achieved critical mass and tend to dominate their product markets.

Actively managed stock funds, on the other hand, by definition aren't content to own a static portfolio of big stocks. They promise, often in so many words, to try to beat the market--to invest in the fastest-growing companies, or the most undervalued companies, or the biggest dividend payers, or some other market niche that may afford above-average returns.


Yet in the modern history of investing, reaching back as far as 35 years, the evidence indicates that the majority of stock funds haven't beaten the S&P but, rather, have continually lagged it:

* In the 35 years through May 31, only 33% of the funds in existence for that era topped the S&P, according to Lipper Analytical.

* Over the last 10 years, the figure was a more dismal 21%.

* The last five years provided the most favorable comparison for active managers, as 43% beat the S&P. But that meant 57% did not.

Worse, those results are skewed in favor of active managers. The reason: "survivorship bias," as only the results of funds that did well enough to survive over each period are included.

To make the comparison more relevant, consider that an investor who committed $10,000 to an S&P index fund 35 years ago would have had $366,500 by this spring.

In contrast, the investor who put $10,000 in the average active stock fund 35 years ago would have $336,300 now, or $30,200 less than the index investor.

That difference may not seem catastrophic for the active-fund investor, but if the goal of every long-term investor is a comfortable retirement, every additional dollar earned obviously will be very meaningful in the long run.

What's more, remember that the average active fund's return is just that: an average. That means plenty of funds earned much less than that average over the last 35 years. With an index fund, at least you know you can't do worse than the market overall.

If most fund managers haven't beaten the S&P, two questions arise: Why haven't they? And why do the vast majority of small investors still trust active managers with their money, instead of simply buying an S&P fund?

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