Subject: Mutual Funds - Index Funds and Beating the Market

Last-Revised: 26 May 1999
Contributed-By: Chris Lott (contact me)

This article discusses index funds and modern portfolio theory (MPT) as espoused by Burton Malkiel, but first makes a digression into the topic of "beating the market."

Investors and prospective investors regularly encounter the phrase "beating the market" or sometimes "beating the S&P 500." What does this mean?

Somehow I'm reminded of the way Garrison Keillor used to start his show on Minnesota Public Radio, "Greetings from Lake Woebegon, where all the women are beautiful and all the children are above average" .. but I digress.

To answer the second question first: The S&P 500 is a broad market index. Saying that you "beat the S&P" means that for some period of time, the returns on your investments were greater than the returns on the S&P index (although you have to ask careful questions about whether dividends paid out were counted, or only the capital appreciation measured by the rise in stock prices).

Now, the harder question: Is this always the best indicator? This is slightly more involved.

Everyone, most especially a mutual fund manager, wants to beat "the market".

The problem lies in deciding how "the market" did. Let's limit things to the universe of stocks traded on U.S. exchanges.. even that market is enormous. So how does an aspiring mutual fund manager measure his or her performance? By comparing the fund's returns to some measure of the market. And now the $64,000 question: What market is the most appropriate comparison?

Of course there are many answers. How about the large-cap market, for which one widely known (but dubious value) index is the DJIA? What about the market of large and mid-cap shares, for which one widely known index is the S&P 500? And maybe you should use the small-cap market, for which Wilshire maintains various indexes? And what about technology stocks, which the NASDAQ composite index tracks somewhat?

As you can see, choosing the benchmark against which you will compare yourself is not exactly simple. That said, an awful lot of funds compare themselves against the S&P. The finance people say that the S&P has some nice properties in the way it is computed. Most market people would say that because so much of the market's capitalization is tracked by the S&P, it's an appropriate benchmark.

You be the judge.

The importance of indexes like the S&P500 is the debate between passive investing and active investing. There are funds called index funds that follow a passive investment style. They just hold the stocks in the index. That way you do as well as the overall market. It's a no-brainer. The person who runs the index fund doesn't go around buying and selling based on his or her staff's stock picks. If the overall market is good, you do well; if it is not so good, you don't do well. The main benefit is low overhead costs. Although the fund manager must buy and sell stocks when the index changes or to react to new investments and redemptions, otherwise the manager has little to do. And of course there is no need to pay for some hotshot group of stock pickers.

However, even more important is the "efficient market theory" taught in academia that says stock prices follow a random walk. Translated into English, this means that stock prices are essentially random and don't have trends or patterns in the price movements. This argument pretty much attacks technical analysis head-on. The theory also says that prices react almost instantaneously to any information - making fundamental analysis fairly useless too.

Therefore, a passive investing approach like investing in an index fund is supposedly the best idea. John Bogle of the Vanguard fund is one of the main proponents of a low-cost index fund.

The people against the idea of the efficient market (including of course all the stock brokers who want to make a commission, etc.) subscribe to one of two camps - outright snake oil (weird stock picking methods, bogus claims, etc.) or research in some camps that point out that the market isn't totally efficient. Of course academia is aware of various anomalies like the January effect, etc. Also "The Economist" magazine did a cover story on the "new technology" a few years ago - things like using Chaos Theory, Neural Nets, Genetic Algorithms, etc. etc. - a resurgence in the idea that the market was beatable using new technology - and proclaimed that the efficient market theory was on the ropes.

However, many say that's an exaggeration. If you look at the records, there are very, very few funds and investors who consistently beat the averages (the market - approximated by the S&P 500 which as I said is a "no brainer investment approach"). What you see is that the majority of the funds, etc. don't even match the no-brainer approach to investing. Of the small amount who do (the winners), they tend to change from one period to another. One period or a couple of periods they are on top, then they do much worse than the market. The ones who stay on top for years and years and years - like a Peter Lynch - are a very rare breed. That's why efficient market types say it's consistent with the random nature of the market.

Remember, index funds that track the S&P 500 are just taking advantage of the concept of diversification. The only risk they are left with (depending on the fund) is whether the entire market goes up and down.

People who pick and choose individual companies or a sector in the market are taking on added risk since they are less diversified. This is completely consistent with the more risk = possibility of more return and possibility of more loss principle. It's just like taking longer odds at the race track. So when you choose a non-passive investment approach you are either doing two things:

  1. Just gambling. You realize the odds are against you just like they are at the tracks where you take longer odds, but you are willing to take that risk for the slim chance of beating the market.

  2. You really believe in your own or a hired gun's stock picking talent to take on stocks that are classified as a higher risk with the possibility of greater return because you know something that nobody else knows that really makes the stock a low risk investment (secret method, inside information, etc.) Of course everyone thinks they belong in this camp even though they are really in the former camp, sometimes they win big, most of times they lose, with a few out of the zillion investors winning big over a fairly long period. It's consistent with the notion that it's gambling.

So you get this picture of active fund managers expending a lot of energy on a tread mill running like crazy and staying in the same spot. Actually it's not even the same spot since most don't even match the S&P 500 due to the added risk they've taken on in their picks or the transaction costs of buying and selling. That's why market indexes like the S&P 500 are the benchmark. When you pick stocks on your own or pay someone to manage your money in an active investment fund, you are paying them to do better or hoping you will do better than doing the no-brainer passive investment index fund approach that is a reasonable expectation. Just think of paying some guy who does worse than if he just sat on his butt doing nothing!

The following list of resources will help you learn much, much more about index mutual funds.

  • An accessible book that covers investing approaches and academic theories on the market, especially modern portfolio theory (MPT) and the efficient market hypothesis, is this one (the link points to Amazon):
    This book was written by a former Princeton Prof. who also invested hands-on in the market. It's a bestseller, written for the public and available in paperback.

  • IndexFunds.com offers much information about index mutual funds. The site is edited by Will McClatchy and published by IndexFunds, Inc., of Austin, Texas.
    http://www.indexfunds.com

  • The list of frequently asked questions about index mutual funds, which is maintained by Dale C. Maley.
    http://www.geocities.com/Heartland/Prairie/3524/faqperm5.html

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