Section IV - Lesson 5
Managed Mutual Funds Versus Index Funds (Part II)
In the 1960’s and early 1970’s, a new concept called low load and no load mutual funds began to be marketed by companies such as Fidelity, T. Rowe Price, and the Vanguard Group. They began selling funds directly to the public by mail and toll-free phone number. Investors liked this approach and soon other sponsors followed suit.
Without a middleman to pay, mutual fund companies could drastically reduce loads, or eliminate them entirely, and make their money instead on the management fees every year on greatly increasing volumes of business. Not only did this business plan succeed for low load and no load funds, but it also forced the full load funds to reduce their loads significantly in order to stay the least bit competitive. Mutual funds became a more desirable product and industry growth exploded.
The idea behind managed funds, regardless of load, was that experienced managers could somehow put together stock and bond portfolios that would “outperform” the general market. One would expect that, through the expertise of these managers, funds would do much better than, say, the Dow Jones Industrial Average, or the Standard and Poor 500 Index over any reasonable period of time. The averages, after all, are not managed. The portfolio manager gets to pick the stocks he wants to go with, while the averages are stuck with whatever stocks make up their particular composition.
A contest between the managed funds and the averages would figure to be a very lopsided event, wouldn’t you think? Kind of like the Lions versus the Christians back in the days of the Roman Empire. Well guess what? A funny thing happens at the Coliseum. The Christians win big and the Lions go home with their tails between their legs.
On average, only about 5% of all managed funds outperform the S&P 500 Index during any given year. And the 5% that make it this year are usually different funds than the ones that made it last year, or the ones that will make it next year. In other words, no manager consistently outperforms the index.
In his highly regarded book, A Random Walk Down Wall Street, Burton G. Malkiel expounded on what has become known as the efficient market theory, or modern portfolio theory. This theory holds that passive investors (as opposed to active traders) holding all stocks forever, can match the gross return of the stock market, and active investors can do no better. Since management fees and transaction fees for passive investors are much lower than those for active investors, passive investors must earn the higher net returns.
Passive investing came to be known as indexing, and the broad-based S&P 500 Index, heavily dominated by large blue chip companies, became the index standard. An overwhelming body of data confirms that, on a long-term basis, the average investment manager has been unable to outperform this index.
As the efficient market theory gained acceptance throughout the investment community, it became only a matter of time before someone would put together an index fund that would own a full participation in a broadly based market index. By far the most logical choice would be to put together a fund that would replicate the S&P 500 Composite Stock Price Index. This index, heavily weighted by the stocks with the largest market capitalization, is said to represent about 70% of the value all U. S. common stocks. Essentially, owning this index would approximate “owning the market.”
The company who pioneered the indexing concept was the Vanguard Group, who introduced an S&P 500 Index fund to the giant institutional pension plan market in 1973, and to the mutual fund industry in 1976. Vanguard’s S&P 500 Index fund is now the largest mutual fund in the world.
In 1994, John C. Bogle, founder of the Vanguard Group, wrote as follows in his book, Bogle on Mutual Funds, (Dell Publishing: 1994). “Aggregate equity indexed assets now approach $400 billion, about one-tenth the market value of all U. S. stocks. The records of these funds have been a tribute to the fact that the efficient market theory—developed during the early 1960’s by a group of brilliant academicians, five of whom subsequently earned Nobel Prizes in economics—actually works, not just in theory but in practice.”
Now the small investor, and even the large investor, had the perfect product for his needs. The market index fund had all of the benefits of the managed fund, except for the management, if you still want to call that a benefit. The investor had diversification, convenience, and he had much lower annual costs. Without the management, he had no management fee, virtually no portfolio turnover, and virtually no expenses.
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