By Thomas D.D. Graff and James M. Dugan, CFA, Cavanaugh Capital Management

Indexing as an investment strategy has come under fire recently with the stock market's woes. The S&P 500, the index with the most money tied to it by far, had its worst first quarter ever. Is it time to give active managers a chance to maximize returns through stock picking? Or should you cash out completely and stash everything under the mattress?

We tapped the research department of Baltimore-based Cavanaugh Capital Management, manager of a wide portfolio of index funds, to address some of the criticisms of indexing amidst this rough market.

If the markets are so efficient, why have some funds outperformed the S&P 500 over long periods of time?

Some mutual funds have indeed outperformed indexes over long periods of time, but the number of outperforming funds is no different than what we would expect from random chance. This does not prove that mutual fund performance is random, but it does mean that we cannot disprove that relative performance is based on luck. More importantly, the seemingly random pattern to mutual fund returns indicates that there is no consistent means of selecting mutual funds which will outperform in the future.

The idea that investment returns might be simply a product of chance might ruffle a lot of feathers in the investment business, but is an idea supported by extensive academic research. Many studies have shown that over long periods of time, most equity investment managers underperform relevant indices by about as much as they charge in fees and incur n trading costs.

Small cap funds (domestic, international, emerging market, etc.) usually outperform the index, so why choose index funds?

Claims that the average small/mid cap and international mutual funds outperform index funds have been greatly exaggerated. According to Morningstar's figures, neither fund group collectively outperformed its benchmark index during the last ten years, and both groups had higher risk scores. Furthermore, the survivorship effect (where the historical data of poor-performing funds is often eliminated) inflates mutual fund averages, so the spread is actually larger than it seems. It is true, however, that a greater percentage of funds in these market sectors outperform compared to large, domestic companies. Regardless, there is no consistent means to select the funds which will outperform. Index funds are the only known way to realize consistent performance in any market.

There are several good reasons to use passive management in less efficient markets, aside from performance. Research costs are considerably higher in these markets, which are reflected by higher expense ratios. Also trading costs are higher in terms of bid/ask spreads. Even if active management is capable of adding more value in less efficient markets, they have more costs to account for as well.

Index funds only work during bull markets. When the market falls, an investment manager can pull investors' assets out of the holdings.

Actively-managed mutual funds usually keep around 5% of assets in cash to cover redemptions, while index funds generally avoid keeping any significant level of cash. During a market downturn, the cash positions in active portfolios will help cushion the fall, but some claim that an active manager can do more. Quoted in the Wall Street Journal's third quarter 1998 Mutual Fund Review, financial advisor David Kliff said, "I like having a manager be able to say, 'I'm not comfortable with Russia, America, Clinton, whatever.'" Unfortunately, few active managers had the foresight (or the luck) to raise cash just before the 1998 correction. In the third quarter of 1998, the average actively-managed fund fell further than its corresponding index.

This argument conflicts with the basic tenets of indexing. A manager might feel "not comfortable" with a particular market sector and might be very comfortable somewhere else, but will s/he be right? The evidence says managers are right about as often as they are wrong. The cash position in actively-managed mutual funds is far more likely to be a drag on a portfolio than a savior. The market is up far more often than it is down, and not being fully invested will hurt performance over the long run.

The S&P 500 has become very tech-heavy. If technology stocks drop, the index funds will fall in tandem.

During the 1990's, many critics of indexing used the growing weight of tech stocks within index funds as evidence of its riskiness, often times by a value-oriented equity manager. The insinuation was that some sort of active strategy was superior. The bear market of 2000 saw the technology portion of the S&P 500 decline 40%. Not surprisingly, the broad S&P 500 fell as well (9%). As a result most value managers paced the S&P 500 for the year.

Which area of the market will produce superior results, value or growth, large cap or small, can only be determined in hindsight. Looking back on 2000, value stocks were far superior to growth stocks, but many articles published at the beginning of 2000 questioning whether value stocks would ever make a comeback. Growth stocks tend to be more aggressive and value stocks tend to be more defensive. In periods of economic weakness, value stocks will outperform. The fact that so many value-oriented funds trounced the S&P 500 during 2000 says nothing about the skill of active managers. If active managers had any particular skill in predicting the market's future, index funds would not outperform so consistently, and would not be so popular.

In fact, financial and technology stocks have a similar weighting within the S&P 500. If financials were to suffer through a severe bear market, value managers would struggle against the index. Indices were created as benchmarks for active managers, and therefore they simply reflect the market the managers track. For example, if the S&P 500 becomes very technology-heavy, it is only because the universe of large cap stocks is also very technology-heavy. In fact, when active managers are said to be over or under weighting a particular sector, it usually means they have a greater or lesser exposure than their benchmark index.

Index funds have considerable latent capital gains. If these funds experience large redemptions, investors would get hit with a big tax bill.

This statement is absolutely true, but it would take preposterously "large redemptions" to create a "big tax bill." This criticism is often pointed specifically at a group of very large and very old index funds, such as Vanguard Index 500. In fact, Vanguard has run simulations of large redemption scenarios and estimates that they can handle losing 10% of assets in a short period of time without making any capital gains distributions. A sudden net-redemption of 10% of assets would be very unusual for any mutual fund. Furthermore, if the redemptions occurred during a market downturn, fund manager Gary Sauter claims that Vanguard could handle losing 40% of assets without making capital gains distributions. Since the Vanguard 500 is the oldest index fund, it is safe to say that other index funds could theoretically handle at least a similar level of redemptions.

Indexing is a self-fulfilling prophesy, which will ultimately turn against itself.

The logic behind this argument is basically that, with so many people investing in the S&P 500 without regard to the value of any of the 500 individually, many of those stocks will become significantly overvalued. Actually, the investment in index funds is probably not that significant. In 1998, only 16% of all new investment dollars came into S&P 500 index funds. Princeton economist Burton Malkiel's research shows that there is no relationship between money flow into index funds and their performance relative to traditional mutual funds.

Index funds will underperform when large cap domestic stocks fall out of favor.

A slightly modified version of this statement is true: "S&P 500 index funds will underperform other market sectors when large cap domestic stocks fall out of favor." Obviously, if small cap stocks begin outperforming their large cap peers, then the S&P 500 will suffer. However, there is no reason to believe the S&P 500 will underperform other large cap funds in such a situation. Too many investors equate index fund investing with just the S&P 500.

If everyone used index funds, there would be no professionals to keep the market efficient.

It is economically illogical for this to ever happen. The investment business is hardly hurting for customers. More than 90% of all equity mutual funds are actively-managed. As long as a few professionals continue to beat the market, and a few always will, investors will be willing to pay large fees to these professionals.

04/06/2001

This article is the property of Cavanaugh Capital Management, and is reprinted with permission. Cavanaugh Capital Management's mission regarding equity indexing is to provide equity clients with a diversified portfolio of index funds while also providing professional monitoring and reporting.