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A New Case for Index Investing

Tim Lee

I recently enjoyed an eloquent, carefully researched white paper published earlier this year that addresses not only the now well-trodden debate between passive fund indexers and active fund managers, but also takes an analytical approach to comparing how a portfolio of passive index funds performs versus a portfolio of actively managed funds.

As Richard Ferri and Alex Benke outline clearly in their paper, "A Case for Index Fund Portfolios - Investors Holding Only Index Funds Have a Better Chance for Success," there has been a great volume of research conducted on the lack of outperformance delivered by active fund managers versus their benchmark indexes. However, there has been relatively little quantitative analysis done about the benefits to investors of constructing portfolios of index funds rather than actively managed funds.

The authors do an admirable job of building a thoughtful analysis while keeping the paper accessible. The methodology behind the research was designed to illustrate the probability of an investor successfully identifying an outperforming active manager (defined by outperformance of a corresponding index fund) across a broad universe of actively managed mutual funds. The idea here is that there are funds or managers which have outperformed their benchmarks in past periods, but the key for investors is to be able to identify them in advance. Here lies one of the central arguments in favor of indexing: Any specific fund selection system generally has a low predictive ability of finding managers who will outperform.

The authors have illustrated the likelihood of an investor choosing an outperforming portfolio of active funds versus building a portfolio of index funds to replicate the respective benchmarks. Their research came to the conclusion that between 60 percent and 90 percent of the time, an investor would fail to select an outperforming portfolio of actively managed funds when compared with an all-index fund portfolio over the same time frame. These odds are staggering in the investment management world.

The research also allows us to compare the win-versus-loss performance. In other words, in the cases where the active portfolio is able to outpace the index portfolio, by how much did the investor benefit? These data points are probably some of the most important outputs of the research. Specifically, the conclusion of the authors' analysis is that when the active portfolio does manage to outperform, it is by a much smaller margin than when the active portfolio underperforms versus the index portfolio. So, when the investor outperforms, she receives a relatively small benefit. However, when she underperforms, she misses much more upside.

The authors do a great job of boiling their results down to three important conclusions. These three key factors are portfolio advantage, time advantage and active manager diversification disadvantage. I'll break down these three concepts and highlight what drives the conclusions of this research below.

Portfolio advantage. The data shows a distinct advantage for portfolios constructed using index funds. The probability of outperformance varied depending on time frame (e.g., 1998-2003 vs. 1998-2012) and composition (e.g., three funds, five funds or 10 funds). However, in all cases, the advantage of using indexes to construct portfolios was significant and persistent. In addition, the win-versus-loss performance affect was consistent so that across all cases where benefit from active management was realized, it had a much smaller benefit than the potential cost if no benefit was achieved.

Time advantage. The research illustrates a clear improvement over time in the benefits of using a portfolio of index funds. This result is likely due to the power of compounding - the longer the indexed portfolio is able to outperform, the more the outperformance is able to build on itself. This data further highlights the value of taking a long-term view of your investment strategy and maintaining a disciplined and consistent approach.

Active manager diversification disadvantage. The final conclusion the authors highlight is that as more active managers are added to the actively managed portfolio, the probability of that portfolio outpacing a similarly diversified portfolio of index funds is reduced. In other words, while diversity in asset classes is generally productive for enhancing portfolio results, diversity amongst active managers is not. This is an important conclusion of this research, and one which has not been widely documented elsewhere.

It also confirms a belief our practice has held for many years: Hiring active managers to attempt to "beat the market" is a losing game.

Finding large trends within business cycles is possible, if not easy. However, identifying specific stocks that will outperform a given benchmark is incredibly difficult, and over long periods, it's nearly impossible to achieve on a consistent basis. As a result, investors should identify where they can consistently produce returns, and then allow the power of the capital markets and compounding to do the work for them.

Timothy R. Lee, CFP®, is a Managing Director and Co-founder of Monument Wealth Management, a Registered Investment Advisory firm located just outside Washington, D.C. in Alexandria, VA. Follow Tim and the rest of Monument Wealth Management on Twitter, LinkedIn, YouTube, Facebook, and their "Off the Wall" blog which can be found on their website. Investment advice offered through Monument Advisory Group, LLC, a Registered Investment Advisor.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.

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