Description of Market and Indices

The US stock market is now comprised of over 5,000 stocks. The market for all of these stocks is the stock market. Stocks tend to move together. Consequently, we can get a picture of how the stock market is doing by looking at an index. An index is a basket of stocks constructed to represent the whole market or a subset of it. The evening news and the daily papers usually quote the Dow Jones Industrial Average which measures the performance of a basket of 30 stocks. Investment professionals prefer the S&P 500 Index. The market value of these 500 stocks cover about 80% of the value of all US stocks. Professional investors pay more attention to the S&P 500 because it is more representative of the economy[1]. There are many indices. For example there are indices to measure the performance of stocks with large market values and indices to measure the performance of stocks with small market values. Some indices measure specific industries.

An index fund is a portfolio designed to track an index. For example, Fidelity offers a mutual fund designed to track the S&P 500 index. It does not take much skill to create an index fund. One just buys the stocks in the index in proportion to their weight in the index. For example, at the end of October 1995, the largest stock in the S&P 500 was General Electric which represented 2.48% of the index. The smallest stock was Morrison Knudson which represented 0.005% of the index. Since it doesn't take much skill to create an index, one can index inexpensively. The expense charged by Fidelity for its index fund is about 0.2% annually compared to more than 1% for the typical equity mutual fund.

Active vs. Passive Management 
Investors pay higher fees to managers who claim to offer better performance. Managers try to achieve better performance through "active" management. Active management involves buying stocks in anticipation of their outperforming the market. As their name suggests, active managers engage in a higher degree of trading than passive managers who buy and hold.

Active managers must make up both for the higher fees they charge and for the higher trading costs they incur. Trading costs include commissions paid to brokers and the spread between the bid and ask price. The bid is the price at which a stock can be sold and is lower than the ask which is the price at which a stock can be bought. For example, a stock might be 50 bid and 50 1/8 ask. If you bought the stock and immediately sold it, you'd lose 1/8 even if there were no commissions. This is a significant cost which never shows on a statement.

Why the Market Will Beat the Average Professional 
It is natural to expect professional money managers and mutual funds to beat the market. They're experts paid to do just that. As I will explain, there are reasons why the market usually beats the average manager.

The investment business is different from other advisory businesses. It is close to a zero-sum game, a very important point. For the most part, investment professionals are the market. Their clients own most of the stocks and do most of the trading. When a manager over weights a stock - that is owns a stock in a greater proportion than its weight in the market - a different manager must be under weighted. For every winning bet, there is a losing bet. On average everyone is the market. So on average everyone should perform in line with the market. However, there is a twist. This would be true if there were no trading costs. As we discussed, there are trading costs that drag down average performance. Therefore, we would expect the average manager to under perform the market even before management fees.

Why Beating the Market Is Luck
If it were easy to beat the market, people would have incentives to become money managers and charge people fees for their abilities. As more people did this the opportunities for beating the market would disappear since it is a zero sum game. As we've discussed, there is survivorship bias. The stock market weeds out those who cannot perform by taking away their money. We're left with a more competitive environment with fewer opportunities for out performance. The irony is that managers fail to beat the market because there are so many intelligent ones, not because they lack intelligence.

Why do you hear so much more about active management than passive? There's a lot more money in selling active management than passive management. The management fees are about five times higher for an active fund than a passive fund. This excludes the brokers who prefer the commissions generated by active managers and the loads that are paid to brokers to sell active funds. The financial press can sell a lot more copy pushing the latest, hottest investment.

On the other side, it doesn't pay for an index fund to advertise. These funds work because their expenses are low. An index fund is a commodity. If two mutual funds both invest in exactly the same fashion, investors would choose the one with the lowest expenses. Thus, if an index fund advertises the benefits of indexing, it would need to increase its expenses. This would diminish its advantage over other funds, especially over other index funds. The result is you are bombarded with information about active strategies but not about passive ones. 

Conclusion 
The purpose of this article is to suggest that you consider using an index fund for your stock investments. The rational side of us would like to think we need evidence of superior quality or performance to induce us to pay more for a service or product. In fact, active management costs more and performs worse. The evidence and arguments why passive management will beat active ones over long periods of time are strong.

I cannot argue that an index fund will beat all active funds. To the contrary, I am sure that some funds will beat the index, especially the shorter the period of time. I am uncertain that it is possible to pick which ones will do well in the future. It is easy to find funds that have done well in the past. The disclosure that past performance is no indication of future performance is made for a reason. Assuming this disclosure is true, we can't use past performance as evidence of future performance. What is the case for active management? 
With an index fund you are certain of near (and probably below) market performance at a low fee. With an active fund, you are certain of a higher fee, but your performance relative to the index is uncertain (but probably below). When you buy an active mutual fund you are guaranteeing to pay a higher fee for the hope of beating the market.

Home | Email