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Question:


How many active fund managers beat an index in the long run, say five years or 20 years? In the grand scheme of things, would you suggest buying index funds or letting my money be actively managed?
-NumberCruncher


Answer:


The short answer is not many over most periods. A recent study by the research firm S&P Dow Jones Indices found that 66 percent of actively managed mutual funds that focus on the American stock market failed to beat the Standard & Poor’s 1500, a benchmark index comprising the stocks of large, medium-sized and smaller companies, in 2012. Over the three and five years through the end of 2012, respectively, 74 percent and 69 percent of funds couldn’t beat the index.

There is a belief that active managers have a better shot at outperforming in segments of the stock market that are not covered extensively by brokerage or other research. The idea is that their own skill and effort will allow them to find companies with strong growth potential and/or cheap valuations that have escaped the notice of others. Here the evidence is mixed. Funds that specialize in shares of mid-sized or smaller domestic companies were beaten by relevant benchmarks in greater proportions than domestic funds in general were. But in one niche, stocks of international smaller companies, active management was much better. In fact, about 90 percent of active managers beat their benchmark over three years, and slightly smaller percentages than that outperformed over one and five years.

The reason that active managers of more mainstream funds get beat by the indexes they’re measured against isn’t that they’re bad; it’s that they’re average. Fund managers own such a substantial proportion of listed securities – stocks and bonds – that together they make up the market, or at least strongly approximate it. Because funds have costs for trading, salaries, research and so on, their returns as a group will nearly match those of the indexes they follow, minus the costs. So in the grand scheme of things, you’re probably better off owning index funds for plain-vanilla asset classes like domestic stocks and Treasury bonds, but for foreign smaller-company stocks and maybe emerging markets, it could pay to invest in the funds of active managers with low fees and strong long-term track records.

-Conrad de Aenlle



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