First, any financial market is a zero sum game.
This means that, after costs and taxes, the average actively-managed
dollar will always underperform the average indexed dollar (and
therefore the markets in which all these dollars are invested).
This is a simple law of arithmetic that will not go away
in the future.
Second, the investment costs associated with actively-managed
mutual funds have generally trended upward over the last decade.
This has occurred despite the fact that investors have poured
huge amounts of money into active funds over this period. The
resulting economies of scale would seem to dictate that these
funds should pass on the cost savings to their investor-shareholders.
This has not happened. At the same time, the costs of investing
in index funds have trended downward as they have become more
popular with investors.
Naturally, there is always the possibility that
the costs of active mutual funds will decrease in the future,
thereby narrowing the cost gap with index funds. But all evidence
to date has shown just the opposite trend - the costs of active
funds continue to go up and the costs of index funds continue
to go down.
Third, actively-managed mutual funds typically
generate relatively large amounts oftaxes while index funds
generate relatively small amounts. Some of the resulting gap
in performance caused by taxes would seemingly be narrowed if
the federal government were to lower tax rates. Congress did
this at the end of July 1997 when it reduced the maximum long
term capital gains tax rate from 28% on investments held more
than one year to 20% on investments held 18 months or longer.
The tax bill provides that in the year 2001 this rate will be
reduced to 18% for investments held five years or longer.
Even though the lowering of tax rates on long
term capital gains is good news for actively-managed mutual
funds, it may be even better news for index funds. The new tax
law clearly encourages investors to hold on to their investments
for longer periods of time. Thus, it favors indexers tax-wise
because they typically do not buy and sell their mutual fund
shares as often as active investors.
It is problematic that the future direction of
tax rates will be a downward one since the federal government
continues to face a myriad of deep- rooted fiscal and budgetary
problems." So active investors who may be counting on Congress
to help them narrow the gap in after-tax performance with indexers
may be in for a long wait.
Fourth, a trend characterizing financial markets
the world over is that they are getting more efficient. Thus,
it isn't getting any easier for active money managers to outperform
such markets - rather, it is increasingly difficult. Even many
prominent active money managers admit this. One such manager
is Ken Gregory who observes: "The markets are getting more
and more efficient. There's so much more data available more
quickly."
While many active money managers will admit that
it is getting more difficult to outperform efficient markets,
they quickly add that there are plenty of opportunities to beat
"inefficient markets," especially those in many foreign
countries. However, the laws of arithmetic that govern the zero
sum game of efficient financial markets also apply to inefficient
markets. In both kinds of markets, the average actively-managed
dollar will underperform the average indexed dollar, after costs
and taxes. This is why the high costs and taxes that are usually
present in inefficient financial markets such as many foreign
markets often adversely impact investment performance more than
the margin by which a money manager is able to beat such markets.
For these reasons, it is likely that in the
future a given index fund will generate net long term performance
superior to most similarly invested actively-managed mutual
funds. This is true for both stock and bond index funds.
For example, a Wilshire 5000 index fund will likely outperform
most actively-managed stock mutual funds over the long run.
It is even likelier that a bond index fund that tracks the performance
of a total market bond index such as the Lehman Brothers Aggregate
Bond Index will outperform most active bond funds. Furthermore,
index funds invested in more specialized asset classes such
as foreign stocks will likely beat most active funds that invest
in foreign stocks.
