Dr. Mark J. Perry, professor of economics at the University of Michigan, pointed out studies supporting the premise that index funds outperform their active counterparts. He quotes a 2014 study done by S&P Dow Jones indices that considered 2,862 active, broad based equity domestic funds that operated since March 2010. The study used funds that ranked in the top quartile for performance in the first year, 2010, and tracked them to see whether they remained in the top quartile through 2014. Out of the funds that had performance that beat 75% of peers only 0.28% attained top 25% performance over 5 consecutive years. The study’s conclusion is that few funds sustain outperformance over time and that some funds with excess returns over their benchmark can become underperformers over time, according to Keith Loggie, senior director of global research and design at S&P Dow Jones Indices.
Stock market efficiency make index funds appropriate for most investors
William D. Nordhaus, a Yale economics professor, highlighted that the 2014 S&P Dow Jones Indices study illustrated active fund performance that resembled results obtained flipping a coin, only slightly worse. Nordhaus agrees that most investors will be better off using index funds as cornerstones of their portfolios. Consistent manager performance on the top quartile over five consecutive years was slightly more probable tossing a coin versus having real world fund managers like the ones included in the S&P Dow Jones 2014 study choosing stocks. However, he concedes that there may be a few talented fund managers that can outperform due to skill and not chance alone. Norhaus and other academics like Paul Samuelson, the late Nobel laureate from M.I.T., argue that stock markets are liquid and efficient. Information is incorporated quickly into trading making it extremely hard to outperform.
Index funds are not core of investors’ portfolios
Dr. Mark Perry concludes that investing habits of most investors remain inefficient. Even though index funds are more likely to outperform active fund managers, only 30% of investors own at least one index fund. Perry speculates that only a minority of index fund owners make the passive vehicles a core part of their portfolios. 70% of investors pay higher fees to invest in active funds that lose them money relative to index funds. Investors need to consider that choosing a passive domestic mutual fund is not a complete investment plan. Diversification among asset classes including bonds, cash, international stocks and other assets such as real estate is important to craft a portfolio that will meet individual goals. So no investor is truly passive as choices are being made at asset class and choice of index to track within an asset class. Some investors may choose an ETF tracking MSCI EAFE for international stocks and their decision results in excluding small cap international and emerging market stocks.