The Power of the Index

By Lawrence Czelusta (from the December 2002 issue of Index Rx)

Imagine competing against Tiger Woods in the 2000's, Michael Jordan in the 90's, Joe Montana in the 80's. We would be among men whose superiority of talents and power would likely cause us to bow in defeat.

Index Rx has also chosen a fearsome adversary. According to Morningstar Reports, the Vanguard 500 Index Fund (VFINX) ranks 46th of the 306 domestic equity funds with twenty year track records. Mathematically, that means the much maligned, lower than a snake's belly, dumber than dirt, VFINX, beat 85% of all these mutual funds. We must keep in mind this doesn't include the many funds that were liquidated or folded into other funds to avoid fund company embarrassment.

Most investment data sources, such as Morningstar Reports, use fifteen years as their longest term in their regular reports. This is understandable as only 580 of the current 8,000 or so domestic equity funds even existed fifteen years ago. Another rumination: the average tenure of a portfolio manager is less than four years. Therefore, the past performance of actively managed funds may mean less than nothing, about as much as the poke the pig is in. Nevertheless, this is all the mutual fund industry gives us to go by.

The Vanguard 500 Index Fund has realized (excluding any taxes) 12.93 percent annualized over the last twenty years.

Of the 45 funds that beat VFINX, four were Fidelity low-load funds: Fidelity Select Healthcare, Fidelity Select Financial Services, Fidelity Contrafund, and Fidelity Magellan. The sector funds are very volatile, risky funds with three percent loads. By the way, who is the current manager of these funds? (Not Peter Lynch, I suppose.)

Another twenty-three funds were no-load funds. Only eighteen funds that beat VFINX were load funds. That means there was only a six percent chance (18 out of 306) that any load fund would have done better than the humble Vanguard 500 Index Fund. That's a one out of 17 chance. Those are much worse odds than Russian roulette (One out of six).

The lesson here is not so much about a fund being no load, lo-load or a load fund. It's about marketing driven, huckster sold, Cheshire-cat-smile-presented to you actively managed funds versus a passively managed index fund.

The proven long term performance superiority of index funds is why Index Rx uses this investment vehicle in its various forms and styles exclusively. Index Rx wants the long term odds to be always in our favor. If you want to be the best, it's the only way to win in the long term. Ask any casino in Las Vegas.

Beating VFINX has seemed easy over the short term of the last couple of years. It has not been easy the last couple of months. And if long term statistics mean anything, neither will it be easy for the next 10 or 20 years. Remember that the S&P 500 represents about 80% of the total domestic stock market.

When we look to the future of our investments beyond that horizon which binds mortal eyes, we come face to face with what has worked in the past, that lamp of experience by which our investment choices are guided. Index Funds have shown the way to investment success, and will continue to do so.