Rule #6- Chose index funds (questioning the Math)

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briang_g
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Rule #6- Chose index funds (questioning the Math)

Post by briang_g »

All,

I am trying to learn about the Boglehead philosophy and I am having trouble with one of the key points, choosing index funds.


Basically its about the the math behind it.

Its rule #6 here > http://www.bogleheads.org/wiki/Video:Bo ... le_.236.29


Within the first minute and 15 seconds, it says something that to me on the surface makes sense, but then doesnt when I think about it more.


It says "the market is a collection of all stocks, all investors, so for every ACTIVE MANAGER that beats the market return, another loses by the same amount".


So this sounded correct to me at first, but then it started to bother me. If it had said"the market is a collection of all stocks, all investors, so for every INVESTOR that beats the market return, another loses by the same amount".

The later statement to me is like baseball, if there are 20 teams and they all play 100 games a season against each other, the average win loss record by definition is 50-50.


However, Mutual funds with active managers dont comprise the ENTIRE market. There are plenty of invdivdual investors I would assume. I have no idea what the split it, but assume that 50% of all wealth in the market is contained in 1000 different mutual funds, and the other 50% of market wealth is owned by indiiduvual investors holding portfolios of indifvidual stocks. Both the individual investors and the mutual fund managers will be picking stocks. Say the active fund managers had better insight into the market, so year after year, they did better than the individual investors. I would say with that hypothetical situations, more than half of the active funds would beat the market, while the individual investors would more often than not do more poorly than the market average.


This question is more about the math than the practicality of what the true track record is for active funds vs market average. I am aware that the active funds cost money to manage, so this hurts thier performance against the market average.

I just seem to have a problem with the statement that "half of active funds will beat the market, half will do worse". That statement makes it seem likes its a mathematical certainty, which it doesnt quite make sense to me.

Brian
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Re: Rule #6- Chose index funds (questioning the Math)

Post by linuxuser »

zero-sum game

finite number of corporate stock shares

I see now that you are the same person asking about the Merrill Lynch stock screening a few days.

Sounds like you don't want to believe in the Boglehead philosophy. Fine.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

It's true that the mathematical statement that active managers must achieve average returns before expenses as a group only holds if they hold all (or nearly all) of money invested.

This article

http://en.wikipedia.org/wiki/Financial_ ... rticipants

gives a figure of 26% for the fraction of U.S. equities owned by individuals in 2005. I would guess (but don't know) that the percentage owned by individuals has dropped somewhat since 2005. Since managers (active and passive) collectively own about 3/4 of the market, I think it's unlikely that their aggregate performance could be very different than the market as a whole.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by Beat The Street »

baw703916 wrote:It's true that the mathematical statement that active managers must achieve average returns before expenses as a group only holds if they hold all (or nearly all) of money invested.

This article

http://en.wikipedia.org/wiki/Financial_ ... rticipants

gives a figure of 26% for the fraction of U.S. equities owned by individuals in 2005. I would guess (but don't know) that the percentage owned by individuals has dropped somewhat since 2005. Since managers (active and passive) collectively own about 3/4 of the market, I think it's unlikely that their aggregate performance could be very different than the market as a whole.
Don't forget about COSTS of investment strategies.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by roymeo »

[Response to snarky comment removed by admin LadyGeek]

Anyway, to the Original Poster:

There's definitely some simplification going on there--which makes sense, if you understood everything already you wouldn't need to watch a explanatory video. Let's break down the sentence. The overall market is indeed ALL the stocks and investors. The "market return" is the average return of all those investors. So a bit of simplification on "average" skews it so there can't be 50 people making nearly all the good (or bad) moves and everyone else makes the bad (or good) moves, but you can see that with as large a market as we're talking about, there's more-or-less an equal loser for any winner.

We're not really interested in whether we're talking about investor, speculator, institution, mutual fund, etc. An average of all those is the 'market return'.

Then you're asking whether active funds might beat some of the other classes of investors, and I guess I'll point you to: all the other posts on this board about how no, they don't, especially when you include fees; all the posts about how even if that weren't true, you have no way to pick those active funds that will do well in the future.

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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

Beat The Street wrote:Don't forget about COSTS of investment strategies.
I haven't forgotten about costs. But the mathematical statement (due to Sharpe) doesn't actually depend on costs. It merely says that if the market consists of passive investors who hold market weights of everything, and active investors who strategize in various ways to attempt to achieve better returns, that both groups in aggregate, must achieve market returns before costs. Research and trading costs, and tax efficency tend to make passive investment come out ahead. But even if this were not the case, the passive managers' returns should all lie very close to the market return, while an individual active manager may have returns much better or much worse than the market. This adds an extra degree of uncertainty to the returns an investor can expect, with no expected higher return, even before costs.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by telemark »

It's a simplification, yes. Put Bill Gates in an elevator with ten homeless people and on average they're all billionaires. The amount of money that overperforms and underperforms the market is the same, but it's not evenly distributed among investors. And the market is not a zero-sum game, so for lose you should substitute "underperform the market."

If you want to view the market as a game with winners and losers, consider who you're playing against. The small investor is out there on the same field with the big professionals. Who is likely to do better?
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Re: Rule #6- Chose index funds (questioning the Math)

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Re: Rule #6- Chose index funds (questioning the Math)

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roymeo
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Re: Rule #6- Chose index funds (questioning the Math)

Post by Brian2d »

To the original poster-
Yes, you are right. Half of all investors must over-perform and half must under-perform overall. Where the average active management mutual fund available to average investors fall in this could be on either side, perhaps lower, perhaps higher, perhaps insignificantly different from the average, prior to expenses. Where expenses are greater, that greater expense comes out of the investment. Historically (I cannot claim to predict the future), after costs the average mutual fund in general has lagged behind both the market return and the return from index funds. If you have evidence to prove that I am wrong on this please let me know. Further, we live under a tax system where frequent trading by active managers hurts the long term returns to individual investors in taxable accounts. For these reasons, the math seems to prefer the average index funds to the average active fund.

Are there active management funds which have outperformed their index after costs? Definitely. Is it possible that those that have in the past will continue to do so, yes. It is also possible that those that have outperformed in the past will under-perform in the future (search for Bill Miller and see what happened to his fund in the financial crisis).

I have not read any previous messages to know for sure whether you are considering active management at Merrill Lynch (as one poster claimed) or somewhere else. I will say that your choices are not only between index funds (which I hold most, but not all of my portfolio in) and investing with Merrill Lynch. Merrill Lynch is a relatively expensive full-service brokerage, and will likely recommend load funds or other relatively high cost investments, based on my experience. If you do choose to invest in actively managed funds, you will likely have better returns within the same asset classes if you choose no-load funds such as Fidelity, T-Rowe Price, or even Vanguard. While I would recommend index funds over actively managed funds in most (not all) cases, I also am fairly confident that no-load funds, after expenses, are likely to outperform load funds.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by briang_g »

[Most of the responses to the snarky / rude comments removed by admin LadyGeek]

To all responders [...removed...]:

Thanks for the feedback, in general the idea of Mutual funds on average getting average perforance before costs, and less than average performace after costs, makes a lot of sense to me. Baws value of funds (passive and active) holding 75% of the equities in the market would support this, as the funds hold a large majority of the equities. As some of you have repsonded, the statement I was asking about in the video, was an oversimplification, but I do believe the general premise. I would still dispute that statement though from a statistical mathematical viewpoint but thats kinda academic, I believe in practice that the rule is valid Thanks for the feedback, Ill probbaly have more questions in general as I am trying to decide where to invest some money, and am exploring various options.

[...removed...]

For the record, I found this site by pure chance when I googled that Merrill lynch fund. I simply registered and blindly opened a post to try to get some feedback as the original thread didnt have any actual fund data. [...removed...]
I will likely be posting many more question on this forum in the hopes of becoming more educated about the Boglehead philossophy. [...removed...] I am simply trying to educate myself.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by JamesSFO »

briang_g wrote:All,

It says "the market is a collection of all stocks, all investors, so for every ACTIVE MANAGER that beats the market return, another loses by the same amount".
The transcript includes a footnote #2:
Here’s why. Remember, “the Market” is the collection of all stocks, all investors. So for every active manager who beats the average market return, another loses by the same amount. Unfortunately, the only way to profit from those winning funds is to know the winners in advance, which is impossible to know.(2)
Which leads you to a paper with the details: http://www.stanford.edu/~wfsharpe/art/active/active.htm

And which would explain the thinking, probably worth reading given who William Sharpe is... I am not sure if the quote is the best possible summation of the Sharpe paper, but for an introductory video it is likely a reasonable way of portraying Sharpe's point.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by swj05652 »

Yes, that statement is not quite rigorous. When an active manager win against the market average, another active manager, or passive fund, or individual investor may take the loss. But in a market where most players are funds, the one who take the loss is very likely to be another fund manager.

In many emerging markets (like Hong Kong), the funds comprise a small part of the market (very different from US or EU). In those markets, active funds often have a better performance. Because they win money from uneducated individual investors.

All in all, the percentage of the funds in a market is important. In US, the funds are almost the entire market.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by bertilak »

To Brian, the OP: I think the reasoning goes something like this.
  1. The entire market is zero-sum.
  2. Funds make up the entire market, or close enough. There simply are not enough individual investors to provide any significant wins or losses to funds.
  3. Index funds mirror the entire market so are also zero-sum.
  4. Therefore the remaining funds (the active funds) must also be zero-sum. QED.
By zero-sum we mean from a trading perspective, ignoring long-term overall growth (we hope) and ignoring costs.

Looking at costs: Active funds have expenses that are greater, at least in total, than those of index funds. There might be both highly efficient active funds and very expensive index funds, but in total, someone has to pay for all that active management which is simply missing from index funds.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by briang_g »

All,

Thanks for the additional feedback. I especially liked the link to the paper by Sharpe.


My final personal conclusion is that it is theroretically possible for the average fund to beat index funds (even after costs), but it probally doesnt matter for two reasons:


1- As many people have pointed out, the funds are such a large percentage of the US stock market that the practical reality is what eveyone is saying, ie, that before costs the average active fund will have the same results as passive funds, so the passive funds are a better deal after costs.


2- I certainly cant tell a good mutual fund from a bad one.


For this reason, I am gonna go with the Boglehead method. I believe the basic premise that index funds are better due to thier low costs. The added huge benifit for me is that I wont have to choose a fund, which seems really difficult (even though that Merrill Lynch potfolio is still drawing me to it with its total performace and the fact that it only lost 10% in 2008)


FYI, my original feeling that the statement was mathematicaly incorrect is supported by many of your comments as well as the Shapre paper (http://www.stanford.edu/~wfsharpe/art/active/active.htm). Here is a quote - "It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after cost. For this to take place, however, the non-institutional, individual investors must be foolish enough to pay the added costs of the institutions' active management via inferior performance".

Does anyone have any links to papers where the analysis of the passive funds vs active funds are done ? By analysis, I dont mean a paper like Sharpe which is theoretical, I mean one where they actually try to compile fund results for many funds over the period of many years.

Randy
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Re: Rule #6- Chose index funds (questioning the Math)

Post by hlfo718 »

Why don't you look at M*'s ranking of the index funds? If you type in ticker VTSMX you will see its ranking in 1, 3, 5, 10, 15 years, all within top 1/3, and I believe this is before taking taxes into consideration.

I know is hard to accept smart managers can't outperform but there tons of ivy league graduates competing in the market so is impossible to identify which one of these smart manager will outperform ahead of time.
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Re: Rule #6- Chose index funds (questioning the Math)

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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

hlfo718 wrote:Why don't you look at M*'s ranking of the index funds? If you type in ticker VTSMX you will see its ranking in 1, 3, 5, 10, 15 years, all within top 1/3, and I believe this is before taking taxes into consideration.

I know is hard to accept smart managers can't outperform but there tons of ivy league graduates competing in the market so is impossible to identify which one of these smart manager will outperform ahead of time.
Past performance doesn't guarantee future results. ;)

I don't interpret the OP's question in the same way. Obviously if nearly all the market is controlled by active managers, they can't all outperform, no matter how smart they are. But if only 10% of the market were owned by active managers and the other 90% by the Beardstown Ladies, then it is plausible to imagine that the active managers could outperform as a group (at least before expenses).

So the question is really which of the two extremes the market is closer to. If only about 25% of the market is owned by individuals (and much of that is probably owned by corporate insiders), then Sharpe's statement as applied specifically to active instiutional investors should approximately be accurate.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by Barry Barnitz »

briang_g wrote:All,

Thanks for the additional feedback. I especially liked the link to the paper by Sharpe.


My final personal conclusion is that it is theroretically possible for the average fund to beat index funds (even after costs), but it probally doesnt matter for two reasons:


1- As many people have pointed out, the funds are such a large percentage of the US stock market that the practical reality is what eveyone is saying, ie, that before costs the average active fund will have the same results as passive funds, so the passive funds are a better deal after costs.


2- I certainly cant tell a good mutual fund from a bad one.


For this reason, I am gonna go with the Boglehead method. I believe the basic premise that index funds are better due to thier low costs. The added huge benifit for me is that I wont have to choose a fund, which seems really difficult (even though that Merrill Lynch potfolio is still drawing me to it with its total performace and the fact that it only lost 10% in 2008)


FYI, my original feeling that the statement was mathematicaly incorrect is supported by many of your comments as well as the Shapre paper (http://www.stanford.edu/~wfsharpe/art/active/active.htm). Here is a quote - "It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after cost. For this to take place, however, the non-institutional, individual investors must be foolish enough to pay the added costs of the institutions' active management via inferior performance".

Does anyone have any links to papers where the analysis of the passive funds vs active funds are done ? By analysis, I dont mean a paper like Sharpe which is theoretical, I mean one where they actually try to compile fund results for many funds over the period of many years.

Randy

Hi Randy:

Here are some links to get you started:

SPIVA: This link takes you to a page providing links to SPIVA scorecards where you can find links to annual reports showing the performance rankings of active managed funds to S&P indexes.

Vanguard Institutional also has an accessible white paper, The Case For Indexing, which provides long term results.

regards,
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Re: Rule #6- Chose index funds (questioning the Math)

Post by pkcrafter »

Brian, Randy?? wrote:
My final personal conclusion is that it is theroretically possible for the average fund to beat index funds (even after costs), but it probally doesnt matter for two reasons:
Can you explain how you reached the conclusion that it's possible for the average fund to beat a market index fund after costs? By definition, a market index must reflect the average of all held stocks before costs are added.


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Re: Rule #6- Chose index funds (questioning the Math)

Post by peppers »

This is from pkcrafter's thread.

https://personal.vanguard.com/pdf/s356.pdf

It's an interesting read, active versus passive.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by peppers »

I see he has joined the discussion.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

pkcrafter wrote:Brian, Randy?? wrote:
My final personal conclusion is that it is theroretically possible for the average fund to beat index funds (even after costs), but it probally doesnt matter for two reasons:
Can you explain how you reached the conclusion that it's possible for the average fund to beat a market index fund after costs? By definition, a market index must reflect the average of all held stocks before costs are added.


Paul
If all equities are owned either by active funds or passive funds, then the active funds can't outperform as a group. But if 10% of the market were owned by active mutual funds and the other 90% were owned by individuals who picked stocks, I would bet on the professionals to outperform the individuals (as a group).

For the record, I'm not questioning the wisdom of buying index funds. The only "active" funds I own are municipal bond funds, for which passive alternatives do not exist.

Brad
Last edited by baw703916 on Sun Feb 03, 2013 12:10 pm, edited 2 times in total.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by pkcrafter »

Here's an article from Rick Ferri who is a regular poster here.

http://www.portfoliosolutions.com/index ... -superior/


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Re: Rule #6- Chose index funds (questioning the Math)

Post by bertilak »

baw703916 wrote:But if 10% of the market were owned by active mutual funds and the other 90% were owned by individuals who picked stocks, I would bet on the professionals to outperform the individuals (as a group).
Two sources I have on my bookshelf say the professional, institutional, managers predominate.

Charles D. Ellis' Winning the loser's Game (5th edition) page 11:
90 percent of all New York Stock Exchange (NYSE) "public" trades are made by investment professionals.
Larry E. Swedroe's The Quest For Alpha page 94:
Today it is estimated that 80 to 90 percent of all trading is done by institutional investors.
...
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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

bertilak wrote:
baw703916 wrote:But if 10% of the market were owned by active mutual funds and the other 90% were owned by individuals who picked stocks, I would bet on the professionals to outperform the individuals (as a group).
Two sources I have on my bookshelf say the professional, institutional, managers predominate.

Charles D. Ellis' Winning the loser's Game (5th edition) page 11:
90 percent of all New York Stock Exchange (NYSE) "public" trades are made by investment professionals.
Larry E. Swedroe's The Quest For Alpha page 94:
Today it is estimated that 80 to 90 percent of all trading is done by institutional investors.
...
There doesn't appear to be enough victims to exploit.
I'm not disputing that--in fact I posted a similar statistic earlier in the thread. My point was that an important aspect of Sharpe's statement is the assumption that the institutional managers are competing mostly against each other, rather than the Beardstown Ladies or Jim Cramer's audience.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by bertilak »

baw703916 wrote:I'm not disputing that
And I was just corroborating it, not implying dispute!
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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

bertilak wrote:
baw703916 wrote:I'm not disputing that
And I was just corroborating it, not implying dispute!
Ok, I misinterpreted your statement. I think we are in pretty complete agreement. :) Thanks for posting those statistics.
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"The Arithmetic of Active Management"

Post by Taylor Larimore »

I just seem to have a problem with the statement that "half of active funds will beat the market, half will do worse". That statement makes it seem likes its a mathematical certainty, which it doesn't quite make sense to me.
Brian:

This short article by a Nobel Laureate should help:

The Arithmetic of Active Management

Best wishes
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Re: Rule #6- Chose index funds (questioning the Math)

Post by briang_g »

I think for the people still hanging in with this thread we are in agreement, although perhaps saying things a little differently. I'll sumerize my opinion, and perhaps interested parties can say if they feel its a good summary, or if they disagree with any of the different scenarios..


Pure theoretical scenario #1:

Assume the enitire market US is made up of active funds, and passive index funds. There are no individual investors in this scenario. The math implies that before costs, the average performance of the active funds will be average. Once costs is factored in, the index funds on average will be better.



Pure theoretical scenario #2:

Assume the enitire market US is made up of active funds, individual investors, and passive index funds. The math inplies that the passive index funds are by there very definition going to return the total market average. The total average of the active funds and the individual investors combined must also be average. However, the average of the active funds may be better or worse than the average of the indivudual investors. If the average of the active funds is significantly better than the average of the individual investors, then even with costs it may be higher than the market average. this theoretical example assumes that the active funds chose stocks on average better than the individual investor. My belief in this scenario is supported by Sharpe in the paper that people had put links in for. Here is the quote from the paper -> "It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after cost. For this to take place, however, the non-institutional, individual investors must be foolish enough to pay the added costs of the institutions' active management via inferior performance"



Practical reality of the US stock Market:

As many people here have indicated via thier own knowledge or referencing other sources, the large majority of holdings in the US stock market are controlled by institutional investors. This makes reality more like the theoretical scenario #1. Also, people have put in links showing multiple studies that look at the real results, and the real results show that the average activily manged funds after costs is lower than passivly manged funds.




Looking back at some of the posts, SWJ summed it more succinctly than I did:

"Yes, that statement is not quite rigorous. When an active manager win against the market average, another active manager, or passive fund, or individual investor may take the loss. But in a market where most players are funds, the one who take the loss is very likely to be another fund manager.

In many emerging markets (like Hong Kong), the funds comprise a small part of the market (very different from US or EU). In those markets, active funds often have a better performance. Because they win money from uneducated individual investors.

All in all, the percentage of the funds in a market is important. In US, the funds are almost the entire market."
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Re: Rule #6- Chose index funds (questioning the Math)

Post by bertilak »

briang_g wrote:SWJ summed it more succinctly than I did:

"Yes, that statement is not quite rigorous. When an active manager win against the market average, another active manager, or passive fund, or individual investor may take the loss. But in a market where most players are funds, the one who take the loss is very likely to be another fund manager."
A slightly stronger statement can be made: "in a market where most players are funds, most of the losses will be taken by another active fund manager." (Passive, index fund, managers are by definition even with the market.)
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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

briang_g,

I think you have summarized it very well (I agree with Bertilak's slight change).

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Brad
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telemark
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Re: Rule #6- Chose index funds (questioning the Math)

Post by telemark »

And some actively managed funds are, if you'll pardon the expression, grossly larger than others.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by pingo »

hlfo718 wrote:Why don't you look at M*'s ranking of the index funds? If you type in ticker VTSMX you will see its ranking in 1, 3, 5, 10, 15 years, all within top 1/3, and I believe this is before taking taxes into consideration.
I wanted to add the caveat that over shorter periods, index funds are almost sure to perform alongside the average mutual fund. So in searching index fund performance at M*, they will usually be given 3 stars and they'll tend to be in the middle of their category performance over the 1, 3, 5 and sometimes even 10 years periods (although 10 years is usually enough time). It is over long periods that index funds show really show their muster and end up ranking high in their categories:

Fidelity Spartan 500 Index Fund (FUSEX) (after costs)
All Large Blend U.S. funds (after costs)
Image

EDIT: See the chart at Morningstar.com
Last edited by pingo on Mon Feb 04, 2013 2:07 am, edited 1 time in total.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

Pingo, I was curious what site you made that plot with. I didn't know one could plot the performance of an entire categroy of funds (large US blends, for example), That's a neat and illustrative graph.
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Re: Rule #6- Chose index funds (questioning the Math)

Post by 1210sda »

bertilak wrote: A slightly stronger statement can be made: "in a market where most players are funds, most of the losses will be taken by another active fund manager." (Passive, index fund, managers are by definition even with the market.)
Thanks bertilak,....that's a very good point. A passive index fund (assuming no tracking error) will neither outperform nor underperform before costs.

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Re: Rule #6- Chose index funds (questioning the Math)

Post by pingo »

^Edited my last post with a source link.
baw703916 wrote:Pingo, I was curious what site you made that plot with. I didn't know one could plot the performance of an entire categroy of funds (large US blends, for example), That's a neat and illustrative graph.
It's nothing fancy. When I plugged in FUSEX at Morningstar.com and then hit the "Chart" button, M* charts FUSEX in blue and compares it to the performance of the Large Blend category as a whole, along with the total returns of the S&P 500. I selected "Maximum" for my time period and for simplicity, I clicked the "x" to eliminate the S&P 500.

To select another category, find the "Benchmark" menu right above the chart and click on it. Aside from the indices, you can compare the performance of several fund categories.

:beer
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Re: Rule #6- Chose index funds (questioning the Math)

Post by jmccann13 »

From what I learned in a Financial Managment course and corroborated in Mr. Bogle's Little Book of Common Sense Investing http://www.amazon.com/gp/aw/d/0470102101, about 20% of actively managed funds beat the market, but not year to year. The main reasoning for investing in an index is to avoid having a losing fund, which is almost guaranteed if investing in active funds. Check this article out: http://money.usnews.com/money/personal- ... benchmarks
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Re: Rule #6- Chose index funds (questioning the Math)

Post by 1210sda »

jmccann13 wrote: The main reasoning for investing in an index is to avoid having a losing fund,
Isn't it more to avoid having a fund .....that underperforms its index....... If the relevant index has a losing year, then a fund that tracks it will also have a losing year......IMO.

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Re: Rule #6- Chose index funds (questioning the Math)

Post by bertilak »

1210sda wrote:
jmccann13 wrote: The main reasoning for investing in an index is to avoid having a losing fund,
Isn't it more to avoid having a fund .....that underperforms its index....... If the relevant index has a losing year, then a fund that tracks it will also have a losing year......IMO.
There might be more than one definition of losing ...
  • Value of holdings goes down: Index funds can lose this way.
  • Doing worse than their benchmark: Index funds, to the extent that they are well managed, do exactly the same as their benchmark so they can't lose in this way.
  • Bad end of a trade (purchased security does worse than sold security): Index funds don't lose in this way because they (generally) do not sell one security in order to buy another. I say "generally" because they will sell a security if it drops out of an index, but this is rare. Index funds are buy and hold as much as possible.
Actively managed funds can lose in all those ways. So yes, index funds can lose but not in as many ways as active funds.
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Index Fund Advantages

Post by Taylor Larimore »

I am trying to learn about the Boglehead philosophy and I am having trouble with one of the key points, choosing index funds. Basically its about the the math behind it.
Brian:

You have received excellent replies about index fund returns and the math behind it which usually results in higher returns than similar managed funds.

In my opinion, the higher returns are only one advantage. There are at least 13 other advantages, enjoyed by index fund investors that I consider equal or more important:

1. Diversification: The increased diversification of index funds results in lower risk. Baer & Ginsler did a study of Standard Deviaton for actively managed funds vs. the total stock market over both 5 and 10-year periods. Their conclusion: "The returns of actively managed funds were 20 to 25% more volatile than the broad market."

2. Consistancy: Vanguard's Total Stock Market Index Fund (VTSAX) ranked among the top 25% of large-blend funds in just two of the past 10 years. Nevertheless, because of it's consistency, only once falling below average, it outpaced 91% of all large-blend stocks after taxes.

3. Continuation: Of 355 actively managed equity mutual funds around in 1974, less than half survive today. Indexers do not have to worry that their fund will disappear.

4. No style drift: We know that asset allocation determines about 90% of portfolio performance. Managed fund allocations often change.

5. No overlap: It is almost inevitable that a portfolio of managed funds will have overlap. This is not a problem with index funds.

6. No manager changes: History tells us that the average manager leaves within five years. Index fund investors do not worry about manager changes.

7. No worry about underperforming a benchmark index: Many current best performing managed funds later seriously underperform (U.S. Growth, Magellan, Legg Mason Value Trust, etc.). It is much more important to avoid losses than to achieve extra gains.

8. No worry about "asset bloat" which often causes large successful funds to under-perform (Magellan).

9. Less cash dilution. Index funds hold less cash than active funds.

10. Less worry that a manager has "lost his touch." Index funds are expected to return to profitability.

11. Tax-Efficiency: Index funds are significantly more tax-efficient than most managed funds. It is after-tax return that counts.

12. Low maintenance: Index funds are simple, predictable, and easy to understand, explain, and maintain.

13. Peace of mind: Indexers know the averages are always working for them. The index investor has much less worry and more free time to spend with family and other more enjoyable endeavors.

Best wishes
Taylor
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Re: Rule #6- Chose index funds (questioning the Math)

Post by baw703916 »

pingo wrote:^Edited my last post with a source link.
baw703916 wrote:Pingo, I was curious what site you made that plot with. I didn't know one could plot the performance of an entire categroy of funds (large US blends, for example), That's a neat and illustrative graph.
It's nothing fancy. When I plugged in FUSEX at Morningstar.com and then hit the "Chart" button, M* charts FUSEX in blue and compares it to the performance of the Large Blend category as a whole, along with the total returns of the S&P 500. I selected "Maximum" for my time period and for simplicity, I clicked the "x" to eliminate the S&P 500.

To select another category, find the "Benchmark" menu right above the chart and click on it. Aside from the indices, you can compare the performance of several fund categories.

:beer
OK, I never realized that M* had the catetory compare feature :oops: Thanks for enlightening me!
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