This year through September, only 28.5 percent of actively managed large-capitalization funds — which try to beat the market through stock selection — were able to outpace the S.& P. 500 index of large-cap stocks, according to a new study by S.& P. In the third quarter alone, it was even worse, with only one in five actively managed large-capitalization funds beating the index.
That isn’t terribly surprising, said Rosanne Pane, mutual fund strategist at S.& P., because active managers tend to have difficulty beating indexes when market leadership changes. And in the third quarter, many stocks that had paced the market for much of this decade began to fall behind. Small-company stocks were finally beaten by shares of big, blue-chip companies; sectors like energy also started to lose ground.
Still, such transitional periods aren’t the only good times for indexing. S.& P. research shows that while active management fared poorly in the third quarter, it has actually been lagging behind the indexes for a considerable period.
Over the five years through the end of the third quarter — a span that included both bull and bear markets — only 29.1 percent of large-cap funds managed to beat the S.& P. 500. What’s more, only 16.4 percent of mid-cap funds beat the S.& P. 400 index of mid-cap stocks, and 19.5 percent of small-cap funds outpaced the S.& P. 600 index of small-company shares. “The long term does seem to favor the indexes,” Ms. Pane said.
For John C. Bogle, founder of the Vanguard Group, which started the first retail stock index fund 30 years ago, the recent success of indexing is self-evident.
“The reality is, fads come and go and styles of investing come and go,” he said. “The only things that go on forever are costs and taxes.” And by simply buying all the stocks in an equity benchmark and holding them for the long run, traditional index funds minimize the transaction costs and capital gains taxes associated with investing, he said.
Mr. Bogle argued that while indexing grew in popularity in the late 1990s — when the Vanguard 500 Index fund, which tracks the S.& P. 500, was consistently returning more than 20 percent a year — the strategy is even more valuable in a period of modest returns. If equities gain only 6 or 7 percent annually in the coming years, the higher investment management fees, transaction costs and taxes associated with actively managed portfolios will take a disproportionate bite out of a fund’s gross returns, he said.
Yet it’s precisely during these stretches of modest returns when individual investors tend to take indexing for granted. After all, there’s nothing sexy about earning mid-single-digit returns through an index fund.
Research Affiliates, an asset management firm in Pasadena, Calif., has built its own set of indexes that get around the problem of market-cap weightings.
The Research Affiliates Fundamental Indexes, or RAFI, instead weigh stocks on other factors such as sales, book value, free cash flow and dividends.
Jason Hsu, director of research and investment management at Research Affiliates, says that this prevents an index from becoming too oriented toward the fastest-growing and largest-capitalization stocks, for example, just because of market momentum.