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"Funds vs. Indexes: Data are Misleading"

Man on Coin Stack

Mr. Clements examines the reasons why actively-managed diversified U.S. stock funds have been trailing the Standard & Poor's 500 Stock Index's gain while international funds have been able to beat Morgan Stanley's Europe, Australasia, and Far East (EAFE) Index. He argues convincingly in regards to U.S. stock funds but less so regarding foreign funds.

U.S stock funds have badly lagged the S&P 500 Index in recent years. Clements claims that investors are not comparing apples to apples when they use the S&P 500 as the benchmark for a diversified stock fund. The S&P 500 contains stocks with the largest market capitalizations, and they have outperformed smaller stocks over the past several years. This large-cap bias has made it tough for funds with smaller stocks to keep pace with the S&P 500 Index. He recommends using the Wilshire 5000 Index of most regularly traded U.S. equities, which includes both large and small companies, as the benchmark index.

Clements provides the same reason for the apparently superior performance of foreign funds: a flawed benchmark. EAFE had a high weighting (about 62%) on Japan at the start of the 90's. With Japan's miserable performance over the past several years, Clements claims that it has been easy for international fund managers to beat EAFE by simply underweighting Japan. But they made the right call on Japan, so why shouldn't they be given credit for it? He reasonably asserts that EAFE should be a better benchmark in the future as Japan's weighting in the index has shrunk to appropriate levels.

Review by Rahul Seksaria, Assistant Editor