Wednesday, December 1, 2010

Active mutual fund managers pick and choose their holdings while Passive indexes simply hold all the investments in their particular category. For decades the financial media has trumpeted the "fact" that index funds almost always "outperform" active managers. Therefore "smart" investors should only buy index funds and avoid the management fees.

But the facts tell a very different story. The first mutual fund that tracked the S&P 500 index was launched by Vanguard on August 31, 1976, symbol VFINX. There were approximately 35 actively managed mutual funds in existence that focused on S&P 500 stocks when this fund began trading. By the end of the decade nearly 80% of the active managers had dramatically outperformed VFINX. The active managers more than doubled the average annual return of the index fund; 13.15% compared to 5.98%.

Then the greatest bull market in history roared to life in the 1980s'. It continued surging until it climaxed with the Dot Com bubble of the late 90's. It was during this giddy, highflying bull market that the myth of "just buy the index" first appeared. During the 80's and 90's the S&P 500 index easily beat the average active manager; 17.55% compared to 14.12%. Indeed, only 15% of the active managers outperformed the S&P 500 index during this time frame.

But just when it looked like a "new era" of steady stock market gains was the birthright of every investor the Dot Com bubble burst in the early 2000s. And like the unprecedented stock gains of the 80's and 90's, the decade of the 2000s has been marked by historic losses. From January 1, 2000 through October 31, 2010 the S&P 500 index generated an average annual return of -.27%. This is the first time in the history of the S&P 500 index that ten years have elapsed without positive annual returns.

Fortunately, the active managers have done better, averaging 1.87% during this very difficult period. And somewhat surprisingly almost 80% of active fund managers outperformed the index; virtually the same percentage that outperformed during the 1970's.

So what can we learn from this exercise? During difficult market cycles, like the 1970s and the miserable 2000s, active managers have proven to add value in excess of their fees. But during raging bull markets like the 80s and 90s investors don't need active managers and can do fine by just buying an index. So at this point you get to decide if you think we're on the cusp of another bull market or mired in an ongoing swamp of economic uncertainty?

If you're like millions of aging babyboomers who hope to retire in the next decade or so your investment choices today will impact you for the rest of your life. Therefore, choose wisely.

The data supporting this analysis was provided by Morningstar.