The Phony Debate About Active and Index Funds

This evidence reveals which type of fund produces the best returns.

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A great deal has been written regarding the purported “debate” about active versus passive mutual funds. A recent blog by Morningstar Advisor is representative. Unfortunately, it sheds more heat than light on the subject by reaching a conclusion that is very difficult to support: Morningstar advises investors to consider using both active and passive funds in their portfolios.

Anyone who believes markets work should feel compelled to eliminate active funds from their investments. As Rex Sinquefield, co-founder of Dimensional Fund Advisors, famously stated in a debate with Donald Yacktman at the Schwab Institutional conference in San Francisco on October 12, 1995: “[S]o who still believes markets don't work? Apparently it is only the North Koreans, the Cubans, and the active managers.”

Here’s what I find extremely odd and very depressing. Every day investors entrust their life savings to active managers of various stripes. They use brokers to pick stocks and bonds and time the market or invest directly with fund families that selectively feature returns of some of their funds that have “beaten the markets” in the recent past. The message is clear: “We did so for the last five years and we can repeat this stellar performance in the future.” Don’t fall for it.

I have been searching for an easy litmus test you can use to determine whether your financial institution really has the investment expertise needed to “beat the markets.” I think I found one. Many brokers sell proprietary mutual funds. These are funds sponsored by their firm. They typically have the name of the sponsoring institution in the name of the fund. Some examples of proprietary funds are: JPMorgan Mid Cap Core A (JMRAX), Goldman Sachs Korea Equity A (GWIAX), and Morgan Stanley European Equity B (EUGBX).

You would think that before a major brokerage firm would attach its name to a fund sold through its vast distribution network, it would want to be sure the managers of those funds were best of class. You would expect the vast majority of them would be able to beat their analyst-assigned benchmark every year, and certainly over the long term. Otherwise, how could they possibly respond to clients to whom they sold these funds when those clients complain they would have achieved better returns by simply investing in the benchmark index?

I selected JP Morgan, Goldman Sachs, and Morgan Stanley for this analysis because they are three of the largest and best-known U.S. investment banks, according to Morningstar Direct. I looked at all of their proprietary funds with data for one-year, three-year, five-year, ten-year, and fifteen-year periods ending July 31, 2012. Here’s what I found:

When I aggregated the proprietary funds of all three firms together, the percentage of underperforming funds ranged from a low of 64.79 percent over a 15-year period, to a high of 76.86 percent over a ten-year period. Stated differently, roughly two-thirds to more than three-quarters of these proprietary funds did not achieve the returns of their benchmark index.

Is it possible that dismal returns by one of the three firms skewed the otherwise stellar performance of the other two? I checked and the results were remarkably consistent. JP Morgan’s underperformance ranged from a high of 77.19 percent over ten years to a low of 65.12 percent over five years. Goldman Sachs’ underperformance ranged from an unbelievable high of 91.18 percent over ten years to a low of 67.12 percent over one year. Morgan Stanley’s underperformance ranged from a high of 66.67 percent for the one and three-year periods to a low of 47.62 percent over a fifteen-year period.

Ask yourself this question: If this is the best the largest U.S. investment banks can do with the funds that bear their name, why are you giving any credence to anything they may tell you about their “investment expertise”? Investing responsibly means paying less attention to the hype and more to the hard data.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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