Note these three key observations:

1. At the end of the half-century, the initial $10,000 investment would have grown to $1,615,000 for the passively managed index fund, versus $1,080,000 for the actively managed traditional fund—a compound annual return of 10.7 percent, compared to 9.8 percent for the average balanced fund (and 10.9 percent for the composite index itself). When time and compounding join forces, this seemingly modest 0.9 percent advantage in annual return for the index fund over the average actively managed fund has created a profound difference in accumulated wealth—fully $535,000. Little things mean a lot.

2. The superiority of the index fund is not a matter of magic. The heavy costs of managed funds accounted for precisely 100 percent of the differential in rate of return. The average balanced fund incurred annual operating expenses of 0.9 percent, on average, during the period, and perhaps another 0.2 percent in portfolio turnover costs—a total handicap of 1.1 percent. The index fund cost was 0.2 percent, an advantage of 0.9 percent. That cost advantage is what made the difference.

3. While managed funds earned annual returns equal to 90 percent of the market returns for a 65/35 stock/bond portfolio, at the end of 50 years the final value was just 61 percent of the value of the market portfolio. For the balanced index fund, however, the final value was 92 percent of that of the market portfolio, more than half again as large as the managed funds.

TEN YEARS LATER

Simplicity in Balanced Funds

The boxcar accumulations of balanced funds over a half-century have of course come down to earth. That’s what happens when we replace the first 10 wonderful years of the period with the dismal results of the past 10 years. But the margin of advantage for the passively managed balanced index fund over its actively managed peers remains virtually unchanged—an advantage of 0.6 percent per year versus 0.9 percent in the earlier era. The principal (and utterly predictable) reason for that advantage remains the same: the substantial cost advantage of the index fund, largely reflected in its lower expense ratio—0.2 percent versus 1.0 percent for its peers, an annual enhancement of 0.8 percent, repeated year after year.

Over the past 15 years, this advantage in return, as it happens, was even larger, even though, given the low stock market returns of that period, both total returns had shrunk substantially. While the average managed balanced fund produced an annual return of just 4.9 percent, the passive balanced index fund again did much better, earning a 6.5 percent annual return. And again, this performance can be primarily attributed to the huge advantage the balanced index fund enjoyed by minimizing its operating expense ratio. Surely, given the dismal market conditions of the past decade, 6.5 percent is a more-than-acceptable return, and a reminder that by balancing the (usually) stable returns of bonds with the (usually) far more volatile returns of stocks, the balanced fund continues to play a remarkably useful role for conservative investors.

Remarkably, despite the dramatic change in market conditions, the cumulative compound return of the balanced index fund relative to the return of the balanced index remained unchanged—97 percent in both 15-year periods. The average managed balanced fund earned only 72 percent in the first period, and only a barely improved 76 percent in the second.

If You Decide Not to Index . . .

But if the beginning of simplicity is the index fund, it need not be the end. History suggests that, in the long run, only one of every five actively managed funds is apt to outpace the market index (after taxes, only one of seven). And some simple commonsense principles should help you to select them and to earn a generous portion of the market’s return—again, all too likely, less than 100 percent. If there are long odds against outpacing the market, going about the task of fund selection intelligently can at least help to guard against a significant failure. Even master investor Warren Buffett, a strong proponent of the index approach, concedes that there may be other ways to construct an investment portfolio:

Should you choose . . . to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note the word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.¹

The costs that actively managed funds incur in buying and selling portfolio securities are hidden, but nonetheless real. Fund portfolio turnover averages some 80 percent annually. It is expensive, perhaps adding as much as 0.5 to 1.0 percentage points (or more) to the more visible cost of fund expenses. So, favor low-turnover funds, but not only because these costs are lower. They also provide substantial tax advantages. The longer that actively managed funds hold portfolio securities, the greater the extraordinary value of deferral of capital gains becomes to their shareholders. Many high-turnover funds are expensive as well as tax-inefficient, so it behooves you to consider after-tax returns, along with present unrealized gains, which could lead to potentially massive future capital gains distributions and the burden of unnecessary taxes. The odds against active managers’ outpacing the after-tax returns of index funds rise even higher. So if you own any funds outside of a tax-deferred retirement plan, don’t forget that taxes are costs, too.

TEN YEARS LATER

Selecting Lower-Cost Funds

Even when the data are examined over shorter periods, and even when the data turn negative, low costs continue to be key to superior returns. While in the most recent five years (as shown in Table 4.1), the lowest-cost funds provided a slightly lower gross (pre-cost) annual return (lagging the high-cost quartile by 0.3 percent), the group’s low-cost advantage (1.3 percent) over whelms that gap, and leaves the lowest-cost funds a full percent age point to the good, a one-third enhancement in annual return.

If we extend this analysis to a more meaningful 15 years, we see a reversion to the more traditional relationship between fund costs and returns. In this case, the low-cost quartile’s 6.7 percent gross return was 0.5 percent higher than the 6.2 per cent return produced by the high-cost group. Along with that superior performance, the low-cost funds’ 1.4 percentage-point expense advantage resulted in a 1.9 percentage-point improvement in annualized net returns, with the low-cost quartile earning an annual return of 6.1 percent versus 4.2 percent for its high-cost peers.

In using the word performance, I am not limiting my interest solely to return. Risk is a crucial element in investing. I especially like to know a fund’s Morningstar risk rating—based on a fund’s returns in the months in which it underperformed the risk-free U.S. Treasury bill—relative to its peers with similar objectives and policies, and relative to all equity funds. That rating serves as a rough guide to how much relative risk the fund typically assumes. There is a difference! Indeed, the risk of the average large-cap value fund (22 percent below average) has carried only half of the risk of its small-cap growth fund counterpart (93 percent above average). Table 4.3 compares the Morningstar risk ratings for the nine basic investment styles. Risk matters. For while future fund returns are utterly unpredictable, large differences in relative risk among funds have proven to be highly predictable.

TEN YEARS LATER

Consistency and Risk

As I wrote a decade ago, “Markets, no matter what you may have come to think, do not always rise.” Well, during the past decade, that 1999 warning came to pass in spades! Consideration of consistency in performance and sensitivity to risk proved even more important than heretofore.

Likewise, my ideas about the importance of consistency in delivering fund returns have also been fully confirmed during the past decade. While the fund that I identified as having had “good” consistency (Washington Mutual) generally measured up to that standard during the 11 years that followed, it surprisingly fell into the bottom quartile in 2004 and 2005. But the fund quickly returned to its consistent pattern thereafter.

The “bad” fund (American Century Growth), on the other hand, moved from inconsistency to remarkable consistency, spending no years in the fourth quartile since 1996, and only one year in the top quartile. New portfolio managers, named in 1998 and 2000, almost certainly accounted for the change for the better—obviously an unpredictable factor in projecting past patterns into the future.

The index fund (Vanguard 500 Index Fund) repeated its earlier consistency in the recent era. While it duplicated its top quartile rankings of 1994 through 1997 in only two of the sub sequent years, I was hardly surprised; indeed, in the earlier edition, I cautioned investors “not to expect the (fund’s) pattern to recur quite this favorably in the future.” But the index fund again avoided the fourth quartile, enjoying second quartile or better rankings in eight of the eleven years, and third quartile rankings in only three—about “par for the course.”

While fund performance demonstrates great volatility, fund risk profiles demonstrate great stability, and the pattern illustrated a decade ago barely budged. Risk continues to rise steadily as we move from large-cap stock portfolios to small, and as we go from value-oriented to growth-oriented portfolios.

TEN YEARS LATER

On Asset Size

When I identified the then-Pilgrim Baxter Growth Fund (now Old Mutual Growth Fund) as a “Problem Fund,” little did I know how serious a problem it would become for its shareholders. The remarkable results it had achieved as a tiny fund in the early 1990s continued as the fund’s assets began to grow, averaging about $1 billion in 1993 to 1995.

But just as investors became captivated by those great past returns, the fun was about to end. The capital poured in, and the fund’s assets topped $6 billion in 1995. But the fund tumbled into the fourth quartile in 1996, 1997, and 1998; again in 2000 and 2001; and yet again in 2003 and 2004—a truly remarkable—if appalling—fourth quartile return in seven years out of nine. Of course, these failures were accompanied by capital outflows that paralleled the capital inflows that came with its perceived earlier success. Some 95 percent of the fund’s assets in 1995 have vanished, and in mid-2009 a mere $300 million of the $6 billion remained. During the past decade, the return earned by the fund’s investors came to minus 6.9 percent per year. Its investors lost some 51 percent of their capital—likely $3 billion gone up in smoke.

Meanwhile, the funds’ founders, Harold Baxter and Gary Pilgrim, raked in hundreds of millions of dollars for themselves—profits from fund management fees; proceeds from the sale of their management company (several times) to financial conglomerates; and ill-gotten gains from engaging in illicit time-zone trading in their own funds’ shares. Surprisingly, no criminal charges were brought, but the two founders settled civil claims by the SEC and the attorney general of New York for a mere $160 million, a drop in the bucket of their awesome personal profits. This “problem fund” proved to be one of the most disgraceful examples of how fund managers abused the trust of fund shareholders during the recent era. Yes, as I wrote in 1999, hot performance by tiny funds should be “a warning flag to intelligent investors.”

Fund	Percent of Investment	15-Year Return
Large-cap	50%	6.5%
Mid-cap	10	9.0
Small-cap	20	7.8
Specialty*	10	10.4
International	10	3.5
Total/average	100%	7.1%
*Health care, in this case.

TEN YEARS LATER

Choosing Too Many Funds

While I’ve left my simple five equity-fund portfolio unchanged, I’m increasingly convinced that all—or virtually all—portfolios should carry a substantial commitment to broad market index funds based on the total U.S. stock market or the S&P 500 Index. The past decade has shown that successfully selecting winning actively managed equity funds is more a hype than a reality; worse, the selection process gives heavy weight to past performance, and performance chasing has proved to be counterproductive. That’s why dollar-weighted returns earned by fund investors (who put more money in funds after their good performance had been achieved) substantially lag the time-weighted returns reported by the funds themselves.

Two other emendations: (1) Think about the (largely indexed) core of your equity fund portfolio as your “serious money” account, and use your guesswork (or insight) to select active—even risky—funds for your “funny money” account. I recommend that the serious money portion represent at least 90 percent of the total. (2) While I talked about international as a single asset class, I now believe it has two distinct components: developed markets (Britain, Germany, France, etc.) and emerging markets (Singapore, China, India, Brazil, etc.). In this increasingly globalized economy I see little reason to invest heavily in the former group, and would prefer to emphasize the latter (with its smaller but more rapidly growing base, and of course its higher risk). But I’d still limit the international component of the portfolio to no more than 20 percent of the equity position.