Don't Believe Everything That You Read

Physician's Money Digest, May 2006, Volume 13, Issue 5

Most investors shouldbe happy that theexaggerated reportsabout the death ofindex funds arebased on apples and oranges. Indexfunds are alive and beating mostactively managed funds as they domost of the time.

Money

The reason I bring this up is that onceagain Wall Street is announcing the victoryof actively managed funds overindex funds based on the following statistics.According to , 2005 wasthe 7th year in a row when the averageactively managed stock fund beat theS&P 500. Also, for the decade endingDecember 31, 2005, actively managedstock funds beat the S&P 500 by 9.14%to 9.07% in annualized returns.

Wrong Benchmarks

The S&P 500 is an index of onlylarge cap stocks that comprise 50%growth and 50% value. So the onlyactively managed stock funds that canbe fairly compared to the S&P 500 arethe ones that invest in a similar universeof stocks. But the average activelymanaged stock fund calculationincludes about 2000 funds that roughlyfall in that category. Since the other6000 funds included in the average primarilyinvest in mid and small capstocks, they are, therefore, not comparableto the S&P 500.

For the past several years, mid andsmall cap stocks have outperformedlarge cap stocks by many percentagepoints. So, if the performance of theS&P 500 in recent years is comparedto an average that is overweightedwith funds of small and mid capstocks, the S&P 500 cannot lookgood. But that does not prove thatactive fund managers have suddenlybecome more successful.

The reality is, whether a fund is outperformingits relevant index on a riskadjustedbasis is one of the most complexquestions in finance, and the comparisonhas to be made over a reasonablelength of time (at least 5 years).One way is to compare funds in each ofMorningstar's nine fund-style categories(eg, large cap value, mid cap value, etc)to an index for that style. Such a comparisonshows that the index for eachstyle bested at least 50% of comparableactively managed funds last year, andthe indexes bested on average 74% ofcomparable funds over the past decade.

Investment Implications

As I have recommended many times,most physician-investors are better offinvesting in total stock market indexfunds, which are based on the DowJones Wilshire 5000 Index or similarindexes instead of chasing the currentlyhot actively managed fund. There aremany inexpensive options availableboth in the form of traditional open-endmutual funds and exchange-tradedfunds. While there will be year-to-yearvariations, over the long run these indexfunds are almost certain to outperformthe average actively managed fund.

However, this is not a perfect solution.You can create a portfolio that isvery likely to outperform these totalstock market index funds by mixingindex funds of different styles in differentproportions and even by throwingin some rationally selected low-costactively managed funds. But this willtake a lot of research and knowledge,or a good financial advisor.

Do not just fall for the claim thatactively managed funds are now theway to go. Almost by definition, the"average" actively managed fund willnever outperform its relevant indexfund over time, because the averagefund is burdened with investmentexpenses of over 2% per year.

Chandan Sengupta, author of The Only

Proven Road to Investment Success (John

Wiley; 2001) and Financial Modeling Using

Excel and VBA (John Wiley; 2004), currently

teaches finance at the Fordham University

Graduate School of Business and consults with individuals

on financial planning and investment management. He welcomes

questions or comments at chandansen@aol.com.