PART III

1. Fund Types and ComparativePerformance, Efficient Markets,Asset Allocation, andMorningstar Analysis PART III

2. Efficient Markets and Mutual Fund Investing :The Advantages of Index Funds Chapter 7

3. JUSTIFICATION FOR USING INDEX FUNDS • Traditionally, the justification for using index funds has been the argument that our securities markets tend to be reasonably efficient. The efficient market hypothesis (EMH) has been a central proposition of the field of finance for over 40 years. Eugene Fama (1970) in an early survey of EMH defines an efficient market as one in which security prices always fully reflect all available information.

4. When information arises about an individual company or about the stock market as a whole, that information gets reflected in share prices without delay. Thus, even an uninformed investor will find that the current tableau of share prices accurately reflects all the information that is known to the market. In such a situation, it would be fruitless for an active portfolio manager to switch from security to security in a vain attempt to buy “undervalued” securities and sell “overvalued” ones.

5. Such an attempt to gain above-average returns would accomplish nothing but to increase transactions charges as well as the taxes that must be paid by the mutual fund shareowner. • The EMH is associated with the view that stock market price movements approximate those of a random walk. If new information develops randomly, then so will market prices, making the stock market unpredictable apart from its long-run uptrend.

6. Thus, neither technical analysis—an attempt to derive the future movement of stock prices by studying charts depicting the past movements of market prices—nor fundamental analysis—the attempt to predict future stock returns from a “fundamental” analysis of accounting data, future corporate investment strategies, competitive conditions, and the like—will allow professional portfolio managers to achieve abnormal (risk-adjusted) returns.

7. I have suggested (Malkiel, 1973), largely in jest, that a blindfolded chimpanzee throwing darts at the stock pages could select a portfolio that would do as well as the experts. In fact, the correct analogy is to throw a towel over the stock pages and simply buy an index fund, which buys and holds all the stocks making up a broad stock-market index. • In recent years, many financial economists have come to question the efficient market hypothesis. At least ex-post, there seem to be several instances where market prices failed to reflect available information.

8. One celebrated example during the late 1900s is when 3Com spun off 5 percent of the Palm shares it owned. Based on the market price of Palm, the 95 percent of Palm still owned by 3Com was worth more than the total capitalization of the parent company. Moreover, periods of large-scale irrationality, such as the technology-Internet bubble of the late 1990s extending into early 2000, have convinced many analysts, such as Robert Shiller(2000), that the EMH should be rejected.

9. In addition, some financial econometricians have suggested that stock prices are, to a significant extent, predictable from past returns or on the basis of certain valuation metrics, such as dividendyields and price-earning ratios. See, for example, Campbell and Shiller (1988a,b),DeBondtand Thaler (1995), Fama and French (1988), and Lo and MacKinlay (1999). • But indexing can be an optimal strategy even if markets are occasionally oreven often inefficient. To understand why this must be so, consider the next logic.All of the securities in any market must be held by someone. These investors as awhole must earn the overall return of the market.

10. If the market produces an overallreturn of 8 percent in any average year, then investors as a group must earn thesame 8 percent before any investment expenses. Of course, there are always somestocks that produce above-average returns, and some investors will earn above-averagereturns in any particular period. But not everyone can be above average.We cannot live in Garrison Keillor’s mythical Lake Wobegon, where all the childrenare above average. Thus, investing must be a zero-sum game, as is illustrated inExhibit 7.1.

12. If some investors are fortunate enough to be holding the best-performing stocks, then some other investors must be holding the poorer-performing ones. All investors as a group hold all the stocks, and it must be the case that they earn the overall market average return before expenses. • But mutual funds charge a variety of expenses. There are, for example, administrative costs of collecting and distributing dividends and preparing reports for the fund’s shareowners and for the government. There are also investment management costs for the portfolio managers who perform the research analyses to determine which securities the fund will own.

13. Suppose that these costs amount to 8/10 of one percentage point per year, or 80 basis points. In that case, the situation will resemble that depicted in Exhibit 7.2. • If in an average year the market produces an 8 percent rate of return, the average investor will earn only 7.2 percent after expenses. Moreover, after expenses, most investors will underperform the overall market average, based on the total capitalization of all the outstanding stocks. After expenses, investing will not be a zero-sum game; investing will be a negative-sum game.

15. From this analysis, the advantages of indexing can be seen clearly. Since index funds do not hire security analysts to pick what are believed to be the best securities and since index funds are buy-and-hold investors who generate limited turnover, index funds can be managed at minimal expense. Indeed, low-cost index funds and ETFs can be acquired at expense ratios of 10 basis points or less (i.e., less than 1/10 of 1 percent). The advantage of indexing is that it allows the investor to achieve the market return at minimal expense.

16. We can summarize the advantages of index funds in this way. If markets are reasonably efficient and generally reflect whatever information is available, then there will be little scope for professional investors to select portfolios of stocks that outperform the market. Stocks of companies with superior prospects will already have their prices fully reflect those prospects. Therefore, active management is unlikely to find large numbers of mispriced securities that will result in consistent above-average results.

17. But even if markets are often or even usually inefficient, it still must follow that most investment managers will underperform the market.All investors as a group must earn the average market return before expenses. The underperformance of active managers must reflect the additional expenses that they incur in running active portfolios. In the next section, we examine the evidence based on the historical returns of equity mutual funds to test whether indexing is an effective strategy in practice.

18. EVIDENCE FROM U.S. INDEX FUNDS • Evidence from actively versus passively managed equity mutual funds in the United States strongly supports the efficient market hypothesis. Most investors have been better off investing in index funds. Passive index funds typically provide higher net returns to the investor than actively managed mutual funds.

19. The Standard & Poor’s (S&P) 500 Index is the most popular index of large-capitalization (large-cap) stocks in the United States. The index represents about 80 percent of the total capitalization of the U.S. equity market. The most popular index funds in the United States (as well as very popular ETFs) have been indexed to the S&P 500 or to an equivalent 500-stock large-capitalization index (see Exhibit 7.3).

21. Exhibit 7.3 shows that over long periods of time, over 60 percent of actively managed large-cap equity mutual funds in the United States have been outperformed by an S&P 500 Index fund (see Exhibit 7.4). • Exhibit 7.4 shows that the average equity mutual fund in the United States (including all categories of funds) has underperformed the index by almost 1 percentage point per year over the 20 years ending December 31, 2008. This difference can be explained by the higher expenses of actively managed funds.

23. The typical active fund carries an expense ratio that is considerably higher than that of a passive index fund. Moreover, active funds have much higher portfolio turnover, leading to higher trading costs (see Exhibit 7.5). • An example of the superiority of index fund investing over the long run is shown in Exhibit 7.5. The exhibit compares the performance of all the U.S. equity funds that existed in 1970 with the return of the S&P 500 stock index. There were 358 equity mutual funds in existence in 1970. Note that only 117 of these funds survived until 2008. The other 241 funds were closed or were merged into other funds.

25. These 241 nonsurvivors were undoubtedly the poorer-performing funds since the more successful funds tend to stay in business. Thus, these data are tainted by “survivorship bias.” We can only compare the long-run performance of surviving funds with the S&P 500 stock index. The exhibit shows that most actively managed mutual funds experienced performance that was inferior to the index. Indeed, one can count on the fingers of one’s hands the number of equity mutual funds that outperformed the S&P 500 stock index by more than two percentage points or more per year (see Exhibit 7.6).

26. Exhibit 7.6 documents the lack of persistence in equity fund performance in a rather dramatic way. The exhibit lists the top-performing 19 U.S. equity mutual funds over the period from December 1993 through December 1999. These were the funds that enjoyed average annual returns that were at least twice as large as the returns for the stock market as a whole. The portfolio managers of these funds were lionized by the press and treated like rock stars in the popular financial magazines.

28. Their above-average returns were generated, however, by concentrating their portfolios in stocks tied to the Internet. A worldwide bubble in such stocks burst during the first quarter of 2000. The exhibit shows that during the next six year period, these funds suffered severe losses and significantly underperformed the stock market as a whole.

29. EVIDENCE IN FAVOR OF PASSIVE MANAGEMENTIN WORLD FINANCIAL MARKETS • Does the evidence in favor of passive management hold outside the United States? The United States has very liquid, transparent, and efficient stock markets. This may not be the case in the rest of the world, particularly in the world’s less developed emerging markets. In this section, I examine the case for indexing the markets outside the United States (see Exhibit 7.7).

30. Turning first to Europe, we can examine the performance of active European portfolio managers. Exhibit 7.7 presents the comparison. We see that over two-thirds of the actively managed large-cap European funds were outperformed by the MSCI Europe index. Similar results can be shown for global equity managers. Exhibit 7.8 examines the investment returns earned by 414 global equity managers compared with the MSCI World Index.

33. Well over half of the active managers failed to outperform the passive world index. Even in emerging markets, many of which are far less efficient than markets in the developed countries, passive management appears to be a winning strategy. Exhibit 7.9 indicates that about two-thirds of the active managers of emerging-market funds were outdistanced by the index. Paradoxically, the very inefficiency of the trading markets in many emerging markets, with relatively large bid–ask spreads and a variety of transactions charges (including stamp taxes on security transactions), makes it difficult for active managers to outperform even in less efficient markets.

35. ACTIVE VERSUS PASSIVE MANAGEMENTIN THE BOND MARKET • Next I examine the efficiency of passive management in the bond markets of the United States and Europe. Exhibit 7.10 presents the results for the United States. It appears that indexing is a particularly effective strategy in the bond markets. Bond funds appear to be commodity-type products.

37. Because passively managed funds charge lower management fees, it turns out that very few active bond portfolio managers are able to achieve net investment returns after expenses that match the net returns of low-cost bond index funds. In Europe, few of the active bond managers were able to outperform their respective benchmarks. Exhibit 7.11 shows the results for the 10-year period ending December 31, 2008.

39. COSTS ARE IMPORTANT DETERMINANTSOF NET RETURNS • Not all index funds investing in U.S. equities are created equal. There are some domestic index funds with annual expense ratios of as much as 100 basis points (one percentage point per year).

40. A high expense ratio destroys a basic advantage of index funds. Every basis point of expenses lowers the net return earned by the investor. Some U.S. index funds and exchange-traded (index) funds are available with an annual expense ratio of 10 basis points (1/10 of 1 percent) per year or less. These are the funds an investor should favor. Index funds with expense ratios greater than 20 basis points per year should be avoided. The industry average expense ratio for actively managed funds is about 100 basis points per year.

41. Foreign index funds and ETFs tend to have higher expense ratios than domestic funds. Low-expense broad international index funds (indexed to the Morgan Stanley Capital International EAFE index of equities in developed foreign markets) might carry an expense ratio of about 25 basis points. (The industry average expense ratio is over 150 basis points for actively managed non-U.S. funds.) EAFE stands for Europe, Australasia and the Far East, and this index contains all the large corporations in the developed nations of the world that are domiciled outside the United States.

42. Index funds specializing in emerging markets carry even higher expense ratios. Low-cost funds and ETFs may have annual expense ratios between 25 and 50 basis points. In addition, there may be a small purchase charge to defray the fund’s costs of buying securities in the less liquid emerging markets. While sales loads (charges of 300 basis points or more) should be avoided by investors, purchase charges of 50 basis points or less for funds that hold illiquid securities are often required.

43. Similarly, index funds holding emerging market or other illiquid securities may impose redemption charges on investors who liquidate their fund shares after a very short holding period. Such charges are meant to discourage short-term trading that would subject the fund to potentially large trading costs, which hurt the long-term owners of the fund’s shares.

44. Costs are just as important for actively managed as they are for passive index funds. A statistical analysis of the net returns from all diversified mutual funds over the 14-year period 1994 through 2008 reveals that the higher the net returns to investors are, the lower the expense ratio of the fund. Moreover, the higher net returns earned by fund investors, the lower is portfolio turnover (i.e., the less the portfolio manager tends to trade). Excessive trading generates transaction charges in addition to the portfolio manager’s fees and administrative costs.

45. Portfolio turnover therefore tends to reduce the net returns available to the investor. In addition, trading can often be very tax inefficient. To the extent that high turnover tends to generate realized capital gains (and often short-term capital gains that are taxed at regular income tax rates), portfolio turnover reduces after-tax returns even further. Investors who hold their funds in taxable accounts will want to avoid funds that employ substantial portfolio turnover.

46. Exhibit 7.12 shows the effect of expenses on net returns. The exhibit compares the net returns of all diversified equity mutual funds that have high versus low expense ratios. The high-expense funds in the exhibit have expense ratios in the top quartile (the top one-quarter) of all funds, while low-expense funds are considered those with bottom-quartile expense ratios. In preparing the exhibit, expenses are calculated by adding the explicit expense ratio of the fund to estimated turnover costs. Every one percentage point of turnover is assumed to increase expenses by one basis point.

48. As the exhibit indicates, the net returns to investors from the funds with the lowest explicit expenses and turnover are more than 200 basis points higher than the returns of the high-expenses funds. In judging the merits of actively managed funds, investors should prefer those with low expenses and low portfolio turnover. Of course, index funds and ETFs, with their rock-bottom expense ratios and very low turnover, are the quintessential funds designed to minimize investment costs.

49. MUTUAL FUNDS VERSUS ETFs • As indicated, ETFs are index funds that trade like stocks. They can be bought and sold at any time during the trading day, unlike mutual funds, which can be purchased and redeemed only at their net asset value calculated at the end of each trading day. How should an investor decide whether to buy index mutual funds or exchange-traded funds?

50. ETFs have three important advantages. • 1. They tend to carry lower expense ratios than mutual funds. • 2. They can, at least in theory, be more tax efficient than mutual funds. If a mutual fund was forced to sell appreciated securities to meet redemptions from the holders of the fund’s shares, it could be required to realize capital gains that must be apportioned to the fund’s shareholders.