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Index Fund Portfolios Reign Superior

Mutual fund portfolios that hold only index funds have a far greater chance for higher returns than those holding actively-managed funds. The evidence in favor of all index funds, all of the time, is irrefutable, overwhelming and important to all investors.

Most articles on index fund investing compare funds in a single asset class, such as comparing broad U.S. equity funds to the S&P 500. These studies are important, but they don’t capture the multiplier effect that is gained by investing in several index funds across multiple asset classes. The odds favoring all index fund portfolios are significantly higher than an individual index fund in any single fund category.

I’ve written extensively on the benefits of index fund investing over the years. Recently, I wrote three articles that quantify the probability of index funds outperforming actively-managed funds in three separate and distinct asset classes. These categories were intermediate-term municipal bond funds, large cap blend U.S. stocks funds and large cap blend foreign equity funds.

Table 1 summarizes the data from the three articles. Listed are the probabilities that a surviving actively-managed mutual fund beat a comparable Vanguard index fund in each of the three categories, over a five-year period ending June 2012. Please read the individual articles for more information on this comparison methodology and a fund list.

Table 1: The Probability for Selecting a Winning Actively-Managed Fund

Source: Morningstar Principia, 5-years ending June 2012

It’s important to note that the three studies include only surviving actively-managed funds and the performance does not factor in any sales load that may be charged.  Closed and merged funds tend to have poor performance prior to being discontinued, and a sales load will always detract from return. Consequently, had discontinued funds and sales loads been considered, then the probability of selecting a winning active fund in any category would be lower than the summary in Table 1.

I used the data from the three previous articles to form portfolios and compare returns relative to an all index fund portfolio. This study was conducted by forming 10,000 randomly selected balanced portfolios from the three asset classes. Each portfolio held one actively-managed fund from the intermediate-term municipal bond study list, the large cap blend US stock study list and the large cap blend foreign equity study list (see each article for fund lists).

These random portfolios were allocated with 40 percent in municipal bonds, 40 percent in US stocks and 20 percent in foreign equity. This allocation was set on June 30, 2007 and no rebalancing took place over the five-year period.

The annualized five-year returns from all 10,000 portfolios were then compared to an all index fund portfolio that had the same 40-40-20 asset allocation. The index portfolio was composed using five-year returns of the Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (ticker: VWIUX), Vanguard Total Stock Market Index Admiral Shares (ticker:VTSAX) and Vanguard Total International Stock Index Fund Admiral Shares (ticker: VTIAX).

VWIUX isn’t an actual municipal bond index fund. However, I consider it to be more of a municipal bond index fund than any actual municipal bond index fund on the market. There are over 3,600 individual securities held in VWIUX. That’s more than 1,500 bonds over the largest municipal bond index fund.  In addition, the expense ratio (ER) for VWIUX is only 0.12 percent. That’s half that average municipal bond index fund ER.

The 10,000 random portfolio five-year annualized returns were individually compared to the three-fund Vanguard portfolio return. To do this calculation, I simply subtracted the Vanguard return from each random portfolio return for five years, ending in 2012. The result was a relative return over or under the Vanguard portfolio.

The 10,000 relative return numbers were then sorted from the worst performing portfolio to the highest portfolio. The results of this sort are illustrated in Figure 1. The X-axis is the return of the Vanguard portfolio (set at 0.0 percent). Underperforming portfolios are to the left and outperforming portfolios are to the right. The relative level of portfolio five-year annualized performance is shown on the Y-axis (vertical).

Figure 1: 10,000 Actively Managed Fund Portfolios Relative to All Index Funds

Source: Morningstar Principia through June 30, 2012 and articles by Richard Ferri

Of the 10,000 relative results, 8179 portfolios underperformed the Vanguard portfolio, 6 tied, and 1797 outperformed.

The 8179 underachievers equaled about 82 percent of the randomly selected active fund portfolios, or less than 1 in 5. The median (middle) underperforming portfolio lagged Vanguard by 1.0 percent annually, and about 41 percent (4,095 portfolios) lagged by 1.0 percent or more annually.

Only 18 percent of the portfolios outperformed the Vanguard portfolio over the five-year period. The median winning portfolio beat the index fund portfolio by only 0.4 percent annually, although only 2.0 percent (205 portfolios) beat the index portfolio by 1.0 percent or more per year.

In summary, less than 1 in 5 active fund portfolios outperformed the all index fund portfolio. The winning 18 percent of portfolios achieved median outperformance of 0.4 percent annualized while the 82 percent underperforming portfolios fell short by 1.0 percent annualized.

Recall that the three fund categories separately had single fund outperformance probabilities ranging from 22 percent to 32 percent, depending on the category. The 18 percent probability for a combined portfolio outperformance is lower than any single fund category. This is an important concept.

The compounding of negatives is a key difference when considering portfolio construction. Portfolios that hold multiple active funds have a lower probability for beating a comparable all index fund portfolio than any single active fund has for beating a single index fund counterpart. The lower portfolio performance is due to negative compounding within each portfolio.

Take a moment to study Table 2. It illustrates the compounding of negatives in a portfolio very well. The table shows that the probability for an active fund portfolio beating an all index fund portfolio decreases over time and with an increase in the number of fund categories. These are key points in my book, The Power of Passive Investing.

Table 2: The Probability that All Active Funds Will Beat All Index Funds

Sources: Larry L. Martin, The Journal of Investing, spring 1993; Allan Roth, “How a Second Grader Beats Wall Street”; Richard Ferri, “The Power of Passive Investing” (margin of error ± 2).

Consider Row 2 in Table 2. An actively-managed five-fund portfolio held for 20 years has only a two percent chance of outperforming a comparable index fund portfolio. Said another way, if you hold five index funds in different fund categories for 20 years, your portfolio has a 98 percent chance of outperforming a  portfolio holding five comparable, actively-managed funds.

In the earlier example, I calculated an actively-managed fund portfolio (with three funds and allocated 40 percent in municipal bonds, 40 percent in large cap blend U.S. equity, and 20 percent in a large cap foreign stock) had an 18 percent probability of outperforming a comparable Vanguard index fund portfolio over a five-year period, ending June 2012. This result is well within the ±2 percent tolerance in Table 2.

The lessons learned from the data should be clear − the probability that an all index fund portfolio will beat an active fund portfolio is very high and it increases when:

1. the holding periods increase, and

2. the number of fund categories increase.

These two factors make an all index fund portfolio strategy extremely powerful for long-term investors. If you wish to diversify the number of holdings in your portfolio and invest for the long-term, the odds for achieving a financial goal with an all index fund combination increase exponentially.

More research and publishing is needed to promote the facts about index portfolio investing. Starting this fall, I’ll be doing more analysis using the robust CRSP Survivor-Bias-Free US Mutual Fund Database. The CRSP database is survivorship-bias free and that brings closed and merged funds into the analysis. I believe the inclusion of all available funds at the time of purchase will lower the odds for active fund portfolios even further than the probabilities published in Table 2.

There is no active versus passive debate. There are facts about index fund investing and then there is the muddying of facts by some who financially benefit from investor ignorance.

In the end, every person must decide how to manage their money in a way that gives them the highest probability for success. This article shows that an all index fund portfolio, all of the time, is an ideal solution. I honestly don’t know why any fund investor would do anything else.