The folly of trying to beat stock market indexes

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It’s been a great five years for the stock market. The Dow Jones Industrial Average and S&P 500 have made new all-time highs. You could hardly miss making money in the stock market — except if you were a mutual fund manager.

S&P Dow Jones Indexes has just released a report showing that over the past five years 76.2 percent of retail mutual fund managers (and an even greater number of institutional fund managers) underperformed the S&P 500 Stock Index!

In the mid-cap space, more than 65 percent of professional money managers failed to match the S&P MidCap 400 Index. And in the small cap arena, where it’s commonly thought that stock selection should provide even greater value, an astounding 80 percent of managers failed to beat the S&P SmallCap 600 index!

Only managers investing in international and international small cap categories, as well as real estate investment trusts, managed on average to beat their benchmarks, according to the just-released survey.

Even worse, on top of this management underperformance, retail investors paid huge fees to these portfolio managers!

The smart investor

When ordinary investors become aware of these dismal statistics, they are likely to change their behavior, saving money and risk by using index funds. That’s been happening dramatically in recent years. It’s estimated that nearly $1 in every $5 invested in stock funds is invested in an index fund, up from less than $1 in every $10 in 2000.

That’s a theme I have been writing about for years: You don’t have to beat the market; all you have to do is be the market. That is, if you just match the average market performance by purchasing an index fund, you will do very well — over the long run!

There has never been a 20-year period, going back to 1926, when you would have lost money in a diversified portfolio of large company stocks (such as the S&P 500 index) with dividends reinvested and sheltered from taxes — even adjusted for inflation. That statistic comes from the Ibbotson market history division of Morningstar.

Americans never want to be “just average.” But it isn’t a bad thing in investing over the long run. The odds are against the ordinary investor to find a professional who can consistently “beat” the market over good times and bad.

Hope for Wall Street

Many money management firms are coming up with new technologies and new strategies for trying to “beat” the average returns of the market.

“Smart Beta” is one of the most widely used terms. Investopedia.com defines smart beta as: “A set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices … to capture investment factors or market inefficiencies in a rules-based and transparent way.”

Smart Beta is a buzzword among portfolio managers. There are even exchange-traded funds (ETFs) that say they use this strategy to “beat” the market. But that brings us back to square one — the desirability and benefits of paying management fees for even the most sophisticated, and non-emotional, computer-driven strategies, designed to outperform the indexes.

“Factor-based investing” is another term similar to “smart beta” — a belief that if money managers can screen for certain factors, and screen out other factors, they can improve on index performance. They strive for “factor efficiency” — the best combination of factors to include and exclude in order to provide greater returns with less risk.

It’s human nature to be competitive. And stock market investing is one of the most intellectually competitive arenas precisely because it is so easy to measure performance over various periods of time.

It’s a great intellectual challenge to try to beat the market. And I don’t blame Wall Street for trying. But they should do that with their own money — not charging fees to use your money to play their games. And that’s The Savage Truth.

(Terry Savage is a registered investment adviser and the author of four best-selling books, including “The Savage Truth on Money.” Terry responds to questions on her blog at TerrySavage.com.)

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