Tuesday, January 8, 2008

Index Funds Beat Most Mutual Funds, Part 2

In part 1, I explained why the average professional money manager doesn’t get better returns than the stock market averages. Once we take into account the high costs charged by professional money managers, we find that index funds beat most actively-managed mutual funds.

However, it is possible to find analyses within the mutual fund industry that seem to contradict these conclusions. This is because mutual fund lists contain only those funds that are still active. Poorly-performing funds get closed or merged with other funds.

Wouldn’t it be nice if we could all throw out our worst performances? “Judge, I’d like to point out that that in 3 out of 5 football games I attended this year, I didn’t go streaking onto the field.”

If we calculate average mutual fund returns after throwing out bad funds, we get an artificially inflated average return that is higher than the returns investors actually received. This is called survivorship bias. In the book “A Random Walk Down Wall Street,” Burton Malkiel found that survivorship bias inflated average returns by 1.4% per year from 1982-1991. A Savant Capital Management study found that returns were inflated by an average of 1.3% per year from 1995-2004.

You might think that survivorship bias isn’t a problem because you don’t want to choose a bad fund anyway. You’d rather just choose one of the best funds. Unfortunately, the funds that have performed well aren’t guaranteed to stay that way. This is especially true of funds that performed well when they were small, and then swelled as investors rushed in looking for high returns.

The very fact that professional money managers dominate the market is what makes it possible for the average investor to use index funds to match the professionals’ average performance without paying high fees. Once we factor in the costs of actively-managed mutual funds, the evidence is clear. The average investor has received higher long-term returns in low-cost index funds than high-cost actively-managed funds.

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