The S&P 500 Index fund has become the bugaboo of money managers throughout
the world by producing excellent pre-tax returns and almost unparalleled
after-tax returns. Although many have written of the inability of money managers
to beat this benchmark, the systematic analysis of why this is the case has
been lackluster. Perhaps it is this more than anything else that allows tabloid
financial journalists to periodically craft fear-mongering stories about
an S&P mania, despite the fact that only about 8% of all money invested
is indexed.
The Standard & Poor's 500 is an index consisting of 500 large companies
with sizable U.S. operations that is maintained by the editorial staff of
Standard & Poor's, a subsidiary of McGraw Hill. Although there is no
set scientific formula for how companies enter and leave the index, the editors
are sensitive to including companies representative of the economy at large
and tend to pull out companies in the midst of long-term decline. Although
the benchmark has existed since the 1923 in some way, shape, or form, its
true rise to prominence only began in the late 1980s with the explosion of
the mutual fund marketing machine.
By establishing the S&P 500 Index as the de facto standard for comparing
mutual fund returns, the industry ironically set itself up for embarrassing
performance thereafter. It has been this embarrassing performance that has
driven awareness about the S&P 500 Index funds to the masses, where
institutions had been hearing that message for almost 20 years. The original
academic work on index investing called it "passive" investing and determined
that it was the only logical response to what was termed the Efficient Market
Theory (EMT). Because academics could find no predictive factors that explained
market outperformance, they reasoned that the best thing investors could
do was purchase the "market."
Part of the underlying work in EMT was the discovery that money management
ability, like just about any other intellectual pursuit, is distributed along
the bell curve. While the distribution of performance was not perfect, most
money managers appeared to cluster around the mean while there were much
fewer who occupied the extremes at either end in any given year. What has
not really been remarked on is why this average mutual fund performance is
systematically below that available in an S&P Index fund. While some
have speculated that the S&P 500 is really not representative of the
market as a whole and not a good benchmark, a more subtle, but powerful reason
exists that reinforces one of the basic rules for generating excess returns
-- don't spend a lot of money.
By definition, a mutual fund's return is the total return of the stock minus
any fees associated with investing the money. Because index funds are managed
almost on autopilot, fees for these vehicles are extraordinarily low. On
the flip side, managed equity funds routinely have expense ratios of 1.0%
or higher, meaning that to match the market after the expenses, the fund
actually has to beat the market before expenses. To beat the market clearly
and decisively, the pre-expense performance has to be extraordinary. In fact,
if you imagine a bell curve measuring returns that has been shifted to the
left of the pre-expense mean by a percent or two to account for fees, you
can easily see why, by definition, the majority of mutual funds have to
underperform the benchmark.
Beyond buying an index fund, the reality of this for your portfolio is quite
simple. Index funds generate market performance by keeping expenses low.
In their rush to put money into the market, individual investors often run
up miscellaneous expenses for trades, investment information, and software
that costs them quite a bit more of their total capital than one to two percent.
For each dollar you pay to invest, you have to make back that dollar plus
some more in order to make any money at all. In order to beat index performance
where expenses have been minimized through a pattern of long-term holding,
you have to be exceptional. Although there are a few individuals that are
exceptional, the majority of people are best served by concentrating on how
much they spend to invest or they risk underperforming on a pre-tax basis
with the same regularity as professional money managers.
See Also