Empty Pockets

Will Active Mutual Funds Continue To Underperform The Market In The Future?

Empty Pockets
Attempts to predict the future are not very profitable expenditures of time or money. But there are a number of reasons why it can be expected that a large majority of actively-managed mutual funds will continue to underperform the market in the future. (This is true whether "the market" is defined as the U.S. stock market whose performance is measured by the S&P 500 index or the Wilshire 5000 index, the U.S. bond market whose performance is measured by The Lehman Brothers Aggregate Bond Index or the Salomon Brothers Broad Investment Grade Bond Index or even portions of these markets or other markets whose performances are measured by other more specialized indexes.)

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.


From Index Mutual Funds: Profiting from an Investment Revolution[/:Author:] Copyright, ©, 1998 by Wendell Scott Simon
Reprinted by permission. All rights reserved.