Chapter 5

On Indexing

Way back in 1978, in the third annual report of Vanguard Index Trust, the first index fund, I used a quotation from English lexicographer Samuel Johnson to make a point: “It was the triumph of hope over experience.” With his inimitable wit, Dr. Johnson was speaking of a man who married for the second time; I was speaking of a poll of pension managers taken by Institutional Investor. Just 17 percent of these money management professionals, the magazine reported, had outpaced the Standard & Poor’s 500 Index during the previous decade, but fully 95 percent expected to outpace the Index in the coming decade.

In the years that followed, what we witnessed was quite the reverse: the triumph of experience over hope. The hope of beating the Index was dashed; the hard experience that had characterized so many professional managers before 1978 has repeated itself over and over. The Standard & Poor’s 500 Index has outpaced 79 percent of all managers of equity mutual funds that survived the 20 years since then. As 1995 began, I had the temerity to publish a booklet entitled The Triumph of Indexing, describing both the relative performance of the Standard & Poor’s 500 Index and the growing acceptance of index mutual funds by the investing public, a trend that I had awaited for so long.

Index Choices

The Standard & Poor’s 500 Composite Stock Price Index includes 500 of the largest corporations in the United States. This index, which dates back to 1926, measures the returns of this group of stocks, weighted by the market value of each. In 1998, the $9 trillion value of these stocks was equal to approximately 75 percent of the $12.2 trillion of all U.S. stocks.

The entire U.S. stock market is measured by the Wilshire 5000 Index. (The name has remained the same, although the index is now composed of 7,400 stocks.) This index began in 1970. Because of its shorter history, it is less widely recognized, although it is clearly more comprehensive. Besides the large stocks represented by the Standard & Poor’s 500, the Wilshire 5000 Index includes the small and medium-size companies that make up the remainder of the U.S. stock market.

Other stock market indexes exist for growth stocks and value stocks in the large, medium-size, and small categories; for various industry sectors; for the markets of most nations and geographical regions; and indeed for the entire global stock market. In addition, indexes exist for the U.S. and world bond markets, and for a wide variety of subsets of the bond market.

In all, it’s fair to say that there is no category of marketable financial assets for which a price index cannot be created. The choices of indexes are limited only by the creativity of the designers. And where there is an index, there can be an index fund. Index funds now track about 60 different indexes; the vast majority of index mutual fund assets are indexed to the Standard & Poor’s 500.

The timing of the booklet, as it turned out, was auspicious. Since its publication, the word triumph has hardly done justice to the colossal success that index funds have enjoyed. On the performance front, the Standard & Poor’s 500 Index, given its bias toward stocks with large market capitalizations, has outpaced a stunning 96 percent of all actively managed equity funds. The more representative all-market Wilshire 5000 Equity Index has outpaced 86 percent of those funds, also an imposing performance. On the acceptance front, assets of index mutual funds have risen more than sixfold, from $30 billion to some $200 billion.

Index mutual funds, which accounted for only 3 percent of equity fund assets in 1995, represented 6.4 percent just three years later. With estimated cash inflow of $50 billion in 1998, index fund flows were equal to 25 percent—fully one-fourth—of total equity fund cash flows. Index funds have become the fastest-growing segment of the entire mutual fund industry.

The index fund is a most unlikely hero for the typical investor. It is no more (nor less) than a broadly diversified portfolio, typically run at rock-bottom costs, without the putative benefit of a brilliant, resourceful, and highly skilled portfolio manager. The index fund simply buys and holds the securities in a particular index, in proportion to their weight in the index. The concept is simplicity writ large.

But since the creation of the first index mutual fund in 1975, based on the Standard & Poor’s 500 Stock Index, the concept has emerged triumphant. Because the index fund is the very essence of simplicity, and because it must be considered as the core investment in the fund-selection process—the baseline against which all other mutual funds must, finally, be measured—I begin Part II of this book with a discussion of its pros and cons. But, confession being good for the soul, I must acknowledge that I have often been described as the apostle of indexing, having started that first index fund nearly a quarter century ago. I am, if possible, a stronger believer in the concept today than I was when I created that fund.

After a slow start, the concept has not only steadily gained acceptance by investors but has come to play a dominant role in the evaluation of traditional, actively managed mutual funds. The index fund, arguably, is now the standard that dominates the debates about investment strategy, asset allocation, and fund selection. When I first looked at the record in 1975, the S&P 500 Index had outperformed the average actively managed mutual fund by about 1.6 percentage points per year during the prior 25 years. Updating the statistics today, its long-term record reflects an annual advantage of 1.3 percent, although in the past 15 years the margin has swelled to 4.0 percent annually. Table 5.1 shows the record of the passively managed index compared to the average actively managed equity fund over various periods.

TABLE 5.1 S&P 500 Index versus Equity Mutual Funds (Annual Returns for Periods Ended December 31, 1997)

TEN YEARS LATER TABLE 5.1 S&P 500 Index versus Equity Mutual Funds (Annual Returns for Periods Ended December 31, 2008)

I fully recognize that during the past 15 years the large-capitalization stocks that dominate the S&P 500 Index have led the overall market by a solid margin. I would emphasize that the accelerating advantage of the S&P 500 Index may well recede, and may even become a shortfall during interim future periods when stocks with smaller market caps return to favor. But its margins of superiority are nonetheless impressive, and surely undergird the powerful endorsement that index funds have received from the academic community and the financial media, from many astute investment advisers, and from the investing public.

But even if the truly extraordinary 3.4 percent margin over the past decade fails to be matched in the future, the future would be bright. Even a sustained difference equal to half that of the past decade—or 1.7 percent annually—would result in dramatically different accumulations of capital. Assume a Standard & Poor’s 500 Index return of 12.5 percent and a 10.8 percent return for the average mutual fund—the actual rates of return over the past 30 years. If those rates of return were to persist over the next 30 years, a $10,000 initial investment would grow to $342,400 in the S&P 500 Index and to $216,900 in the managed funds, a staggering $125,000 margin that would surely represent a continuing triumph. Figure 5.1 presents the results of each investment, compounded annually, over 30 years.

Whether such a margin will hold in the future, however, is mere speculation. What is not speculative is the fact that the lion’s share of the margin is accounted for by the simple fact that market indexes incur no cost, whereas mutual funds incur heavy costs. Indeed, since total annual costs incurred by the average equity mutual fund have grown from as little as 1.0 percent of assets, or perhaps a bit more, during the 30 years prior to 1975 to at least 2.0 percent today, it becomes clear that mutual fund costs have been largely responsible for creating the industry’s lag, and that the recent superior returns of the large-cap stocks that dominate the Standard & Poor’s 500 Index have simply represented, as it were, the icing on the cake.

The financial press in particular has begun to sing indexing’s praises. In early 1997, index funds were recognized in major front-page articles in both the New York Times and the Wall Street Journal. At almost the same time, Time and Newsweek ran solid indexing stories. The most enthusiastic endorsement came from Money magazine, which, in 1995, was generous enough to headline a lead editorial by Executive Editor Tyler Mathisen: “Bogle wins: Index funds should be the core of most portfolios today.” Like Saul on the road to Damascus, Money had experienced an epiphany.

FIGURE 5.1 Growth of $10,000 over 40 Years: S&P 500 Index versus Equity Funds*

If we use the dictionary definition of apostle—“a messenger, specifically one who first advocates an important belief or system”—I suppose I might qualify as the apostle of the index mutual fund. Ever since 1951, when, in the course of my Princeton University thesis about the mutual fund industry, I expressed doubt about the ability of fund managers to outpace the stock market averages, the vague idea of a market index fund had lingered in my mind. And since the creation of the Vanguard Index Trust in 1975, I have been preaching the gospel of index investing with increasing fervor and conviction.

The Lessons of History

I have long believed that it is important to have a sense of history. The history of the index fund serves as a good beginning to understanding its merits. I did not invent the concept of indexing, but I had been a long-time believer in the concept. I was confident that it could—against all odds—become a reality in the world of mutual funds. Not only did it make sense, but it dovetailed with my conviction that low costs truly make a difference—if not the difference—in emulating the returns available in financial markets. As I have noted, history tells us that doing so is hardly a modest goal for the long-term investor.

The pioneers of the indexing concept were William Fouse and John McQuown of Wells Fargo Bank. During 1969-1971, they had worked from academic models to develop the principles and techniques that led to index investing. Their efforts resulted in the construction of a $6 million index account for the pension fund of Samsonite Corporation, with a strategy based on an equal-weighted index of all equities listed on the New York Stock Exchange. Fouse described its execution as “a nightmare.” The strategy was abandoned in 1976 and was replaced with a market-weighted strategy using the Standard & Poor’s 500 Composite Stock Price Index. The first accounts run by Wells Fargo were components of its own pension fund and that of Illinois Bell Telephone Corporation.

Slightly later in 1971, Batterymarch Financial Management of Boston decided independently to pursue the idea of index investing. The developers were Jeremy Grantham and Dean LeBaron, two of the founders of the firm. Grantham described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the “Dubious Achievement Award” from Pensions & Investments magazine in 1972. Two years later, in December 1974, the firm finally attracted its first index client.

In 1974, the American National Bank in Chicago created a common trust fund modeled on the S&P 500 Index. A minimum investment of $100,000 was required. By that time, the idea had begun to spread from academia, and from three firms that were the first professional believers, to a public forum. Gradually, the press began to comment on index investing. A cri de coeur calling for the creation of index funds came from three remarkably intelligent and farsighted observers. I still treasure their articles, which inspired me nearly 25 years ago and read just as well today.

“Challenge to Judgment”

The first article was “Challenge to Judgment,” by Paul A. Samuelson, Professor of Finance at the Massachusetts Institute of Technology, and a Nobel laureate in economics. In the Journal of Portfolio Management (Fall 1974), he pleaded “that, at the least, some large foundation set up an in-house portfolio that tracks the S&P 500 Index—if only for the purpose of setting up a naïve model against which their in-house gunslingers can measure their prowess. . . . Perhaps CREF (College Retirement Equities Fund) can be induced to set up a pilot-plant operation of an unmanaged diversified fund, but I would not bet on it . . . [or] the American Economic Association might contemplate setting up for its members a no-load, no management fee, virtually no transaction-turnover fund.” He noted, however, what might be an insurmountable difficulty: that “there may be less supernumerary wealth to be found among 20,000 economists [to provide capital for the fund] than among 20,000 chiropractors.”

Dr. Samuelson concluded his challenge by calling on those who disagreed that a passive index would outperform most active managers to dispose of “that uncomfortable brute fact (that it is virtually impossible for academics with access to public records to identify any consistently excellent performers) in the only way that any fact is disposed of—by producing brute evidence to the contrary.” There is no record that anyone tried to produce such evidence, nor is it likely that it could have been produced. But Dr. Samuelson had laid down an implicit challenge for somebody, somewhere to launch an index fund.

“The Loser’s Game”

A year later, Charles D. Ellis, managing partner of Greenwich Associates, wrote a seminal article entitled “The Loser’s Game” in the Financial Analysts Journal (July/August 1975). Ellis proffered a provocative and bold statement: “The investment management business is built upon a simple and basic belief: professional managers can beat the market. That premise appears to be false.” He pointed out that, over the preceding decade, 85 percent of institutional investors had underperformed the return of the S&P 500, largely because, in an environment in which institutional investors have become, and will continue to be, the dominant feature of their own environment, the costs of institutional investing have consumed 20 percent of the returns earned by the managers, “causing the transformation that took money management from a Winner’s Game to a Loser’s Game. The ultimate outcome is determined by who can lose the fewest points, not who can win them.” He went on to note that “gambling in a casino where the house takes 20 percent of every pot is obviously a Loser’s Game . . . so money management has become a Loser’s Game.”

Ellis did not call for the formation of an index fund, but he did ask: “Does the index necessarily lead to an entirely passive index portfolio?” He answered, “No, it doesn’t necessarily lead in that direction. Not quite. But if you can’t beat the market, you should certainly consider joining it. An index fund is one way.” In the real world, of course, few managers indeed have consistently succeeded in achieving an annual return sufficient even to offset their costs and thereby match the index, let alone surpass it. Even those few have been exceptionally difficult to identify in advance.

Fortune Leads to a Flood Tide

“There is a tide in the affairs of men, which, taken at the flood, leads on to fortune.” Shakespeare put those words in Brutus’s mouth. Ironically, in the field of index funds, fortune, in a sense, helped turn the tide of investment affairs toward index funds. In July 1975, Fortune magazine published a third landmark article. “Some Kinds of Mutual Funds Make Sense” was written by Associate Editor A. F. Ehrbar. Ehrbar came to some conclusions that may seem obvious today, but were then hardly the accepted wisdom: “While funds cannot consistently outperform the market, they can consistently underperform it by generating excessive research (i.e., management fees) and trading costs . . . it is clear that prospective buyers of mutual funds should look over the costs before making any decisions.” He concluded, “Funds actually do worse than the market.”

Ehrbar despaired that an index mutual fund would be created very soon, noting that “there has not been much pioneering lately and the mutual-fund industry has not provided an index fund.” But he described the best alternative for mutual fund investors: “A no-load mutual fund with low expenses and management fees, about the same degree of risk as the market as a whole, and a policy of always being fully invested.” He could not have realized that he had described, with some accuracy, the first index mutual fund, which was soon to be formed. But that is what he had done.

Opportunity Is the Mother of Invention

Together, these three clarion calls for an index mutual fund were irresistible. I could no longer contain my enthusiasm for the opportunity to be in the vanguard, as it were, of the development of the index fund. Based on my research on past fund performance, well known in academia but acknowledged by few in the investing profession, I was confident it would work. Further, the firm I had founded in 1974 was focused on low cost, precisely the key to having an index fund that would emulate a cost-free index. It was the opportunity of a lifetime: to prove that the basic theory enunciated in these articles could be put into practice and made to work in a real-world framework. Alas, there was no demand for it by the investing public. So I relied on Say’s Law (after French economist Jean Baptiste Say): “Supply creates its own demand.” Before 1975 came to its close, Vanguard had created the first index mutual fund, modeled on the Standard & Poor’s 500 Composite Stock Price Index.

For a long time, my preaching fell on deaf ears. A brief review of the first index mutual fund’s faltering start, in terms of both the relative performance of the Standard & Poor’s 500 Index and the fund’s labored cash inflow; its all-too-gradual acceptance by the investing public; and, finally, its extraordinary success in the late 1990s, will provide a good backdrop against which to examine some of the long-standing criticisms of indexing. The record should enable us to come to grips with the arguments crafted by critics who are skeptical that its extraordinary success can persist. In exploring the merits of indexing in greater detail, I hope to demonstrate that it is an extremely powerful strategy for the intelligent long-term investor.

TEN YEARS LATER

The Triumph of Indexing

Few investors or financial market insiders acknowledged what I described a decade ago as “the triumph of indexing.” But after the events of a decade-plus since then, it would be impossible not to agree that indexing, like it or not, has indeed triumphed. In the previous edition, I noted that index mutual funds, then with total assets of $200 billion, had grown from 3 percent of equity fund assets in 1995 to 6.4 percent in 1998. By mid- 2009, index fund assets had soared to $460 billion, representing 11 percent of equity fund assets. And cash flow into index funds has been even stronger. While investors liquidated $281 billion of actively managed funds on balance during the past two years, they actually added $50 billion to their index fund holdings.

The returns earned by the S&P 500 Index have also consistently remained superior. Recent data from Morningstar show that a low-cost index fund tracking the S&P 500 would have outpaced a majority of its large-cap peers in six out of the past eight years. Even in those two lagging years, the index fund outpaced 49 percent and 40 percent of peers, a “losing” record that would be the envy of many active managers.

While the current version of Figure 5.1 is not quite as imposing as the version from the first edition, the 50-year margin of 1.4 percent is almost exactly equal to the 1.3 percent advantage that the S&P 500 Index earned when I first examined this comparison for the 30-year period 1946-1975 in preparation for my recommendation to the Vanguard directors that we form the world’s first index fund.

Updating Figure 5.1 through 2008, the comparative record of the S&P 500 looks remarkably similar to the first edition’s version. With the dark decade just ended, the $346,117 final value of an initial $10,000 investment is barely above the $342,400 reported in the 1999 edition, although the cumulative return of the average fund had declined from $216,900 to $201,513. A $144,604 enhancement in financial value by owning the index fund—fully 14 times the initial investment—would seem to fully justify (and then some!) the choice of the term triumph.

Indexing Is a Long-Term Strategy

The success that indexing has enjoyed in recent years has been based in part on recognition that acquiring and holding, at extremely low cost, a broadly diversified portfolio dominated by the large, high-grade stocks that dominate the capitalization weight of the market itself is an intelligent long-term strategy and a highly productive one as well. That success has also been engendered by the remarkable performance of the Standard & Poor’s 500 Index over the past five years, during which its margin of advantage over the average U.S. equity mutual fund has been the highest in history.

But it is the long-term merits of the index fund—broad diversification, weightings paralleling those of the stocks that comprise the market, minimal portfolio turnover, and low cost—that commend it to wise investors. Consider these words from perhaps the wisest investor of all, Warren E. Buffett, from the 1996 Annual Report of Berkshire Hathaway Corporation:

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

No matter what the future holds, long-term investors who have chosen an index strategy because of its merits are unlikely to be disappointed. On the other hand, short-term investors who have chosen an index strategy simply because they expect a continuation of the highly superior returns demonstrated by the Standard & Poor’s 500 Index in the recent past are likely to regret their choice. The historical record makes it clear that the S&P 500 Index has encountered intervals of significant shortfall relative to the average mutual fund. Figure 5.2 shows the percentage of mutual funds outperformed by the S&P 500 Index each year since 1963.

Despite its overall success, there were three periods in which the S&P 500 Index lagged, as reflected in Figure 5.2: 1965-1968, 1977-1980, and 1991-1993. Why? The first period included the “go-go” era of investing, when extremely risky small stocks provided extraordinary returns, and the mutual fund industry responded by creating large numbers of highly aggressive go-go funds. The conservative character of the industry changed during this period; funds accepted uncharacteristically high risks, and the S&P 500 Index’s more modest short-term rewards made it look inadequate. The perception grew that mutual fund managers could easily outpace the market. However, when the go-go bubble burst in 1968, these newly formed funds collapsed, the returns of the average fund slumped, and the S&P 500 Index reclaimed its wide margin of superiority in 1969 through 1976.

FIGURE 5.2 General Equity Funds Outperformed by the Standard & Poor’s 500 Index (1963-2008)

The second aberration occurred quickly thereafter. In 1977 -1980, as the stock market continued to emerge from its decline in 1973 and 1974—an amazing 50 percent, from high to low—smaller stocks finally returned to the fore. Their recovery was rather later than that of their large -cap cousins. And three of the large stocks that then dominated the S&P 500 Index (IBM, 7.2 percent; AT&T, 6.4 percent; and General Motors, 2.6 percent), but were held in much smaller proportions by the highly diversified mutual funds, did particularly badly. On average, they turned in a four-year cumulative return of 7 percent, compared to a stunning 69 percent gain for the remaining stocks in the S&P 500 Index. (Overall, the Index’s cumulative gain was 55 percent.) As in the aftermath of the go-go era, the situation then began to return to normal, and the Index reasserted its strength for the next eight years.

Then came the most recent period of an S&P 500 Index shortfall. The primary reason was elemental. During 1991-1993, small and midsize stocks did better than large stocks. The S&P 500 gained a respectable 15.6 percent annually during this period, but the rest of the market rose at the rate of 22.5 percent.^k As a result, the S&P 500 Index outpaced only (if that is the right word to describe what is in fact not so far from a parity of return) 44 percent of all actively managed funds—less (but not much less) than one-half. (The all-market Wilshire 5000 Equity Index, with a return of 17.7 percent, outpaced 53 percent of the equity funds.) That shortfall, however, was quickly followed by the largest sustained margin of superiority the S&P 500 Index has ever achieved. During 1994-1998, the S&P 500 Index outpaced 75 percent to 90 percent of managed funds over five consecutive years.

After such a sustained run, it would hardly seem surprising if the large-stock-dominated S&P 500 Index were to take a pause. It continues to be dominated by large companies that are global in reach, including General Electric at 3.1 percent of the weight of the S&P 500 Index capitalization; Microsoft, 2.4 percent; Coca-Cola, 2.2 percent; Exxon, 2 percent; and Merck, 1.6 percent. However, it is less concentrated. Today’s five largest stocks account for 11 percent of the Index, only half the 22 percent weight of the five largest industrial giants of two decades ago. Those five former leaders, interestingly, now represent only 8 percent of the S&P 500 Index’s weight. This large reduction in their importance underscores that the sheer force of indexing has succeeded in overcoming this potential impediment. For new and growing companies have picked up the slack, enabling the S&P 500 Index to maintain its long-term performance leadership.

As the markets march on, times change and conditions change. And faith in an indexing strategy based on the widely celebrated success of the Standard & Poor’s 500 Index will inevitably be tested from time to time in the years to come. Still, as a long-term strategy, it remains compelling.

TEN YEARS LATER

Indexing as a Long-Term Strategy

After its extraordinary superiority during the five years from 1994 through 1998 (when the S&P 500 Index outpaced from 75 percent to 90 percent of all managed equity funds year after year), I suggested that “it would hardly seem surprising if the large-stock-dominated S&P 500 Index were to take a pause.” And so it did. Tested though it was in the subsequent 10 years, the Index nonetheless outpaced at least 50 percent of equity funds in five of those years, including more than 60 percent in two years. Indexing remains compelling as a long-term strategy.

The S&P 500 Index Is Not the Market

The term index fund is all too often used interchangeably with one particular form of index fund: a fund modeled on the Standard & Poor’s 500 Index. The first index mutual fund was structured in precisely that form, simply because the S&P 500 Index was: (1) the standard most widely followed by institutional investors in measuring their relative performance and assessing the results of their portfolio managers (mutual funds, in those days, generally didn’t provide investors with comparative standards); (2) the more soundly structured of the two best-known indexes (stocks are weighted by market capitalization rather than, as in the case of the more familiar Dow Jones Industrial Average, by the price of one share of stock in each of only 30 companies); and (3) representative of 90 percent of the value of the entire stock market 25 years ago (it now represents about 75 percent of the value), and thus a solid proxy for the market. When the second index mutual fund appeared a full decade later, it too was S&P 500-based, as was a large majority of all the index funds that followed.

But the 75 percent of the market now represented by the large-cap stocks in the S&P 500 Index is not the market. Excluded are stocks with medium and small market capitalizations (and, typically, higher volatility). Nonetheless, the essential theory of indexing is based on owning all of the stocks in the market. Theoretically, the preferred standard for the basic index mutual fund would be the Wilshire 5000 Equity Index of all publicly held stocks in the United States.

With the large-cap stocks in the S&P 500 leading the way in the long bull market that began in 1982, the original 500 index funds have done especially well, and pragmatism has triumphed over dogma. But all-market index funds are slowly coming to the fore. Vanguard was the first of only a handful of firms to form mutual funds based on the Wilshire 5000 Equity Index. But the S&P 500 Index remains the principal measurement standard used by most mutual funds and pension accounts.

Does it matter which index is chosen? In the long run, no. Since 1970, when the Wilshire 5000 Equity Index began, the total returns of the two indexes have been identical: both have earned annual returns averaging 13.7 percent—a remarkably precise coincidence. It follows, then, that mid-cap and small-cap stocks, constituting 25 percent of the market’s weighting measured by the Wilshire 4500 Equity Index, have also provided an average return of 13.7 percent. The 1970-1998 period is the longest period we have for comparison, although any period - dependent comparison is inevitably suspect. The precise parity of returns may overstate the case somewhat, but I am confident that we have learned something important when we observe that the returns of stocks with different investment characteristics converge so tightly over nearly three full decades.

But in the short run, yes: The difference does matter from one year to the next. As we look at comparisons that show the percentage of diversified U.S. equity mutual funds of all types that have been outpaced by the S&P 500 Index, its leadership in recent years has overstated its inherent strengths, even as its followership during 1976 -1979 had overstated its weaknesses. For example, in that latter period, the S&P 500 Index outperformed 22 percent of all equity funds, but the Wilshire 5000 outperformed 44 percent. In 1995-1998, on the other hand, the S&P 500 outpaced 82 percent of all funds, while the Wilshire 5000 outpaced only (again, if that is the correct word) 72 percent. Figure 5.3 compares the relative standing of the two indexes over the past 28 years.

It is difficult to find a perfect standard against which to measure mutual fund returns. Although the total assets of U.S. equity funds are invested in proportions rather similar to those of the total value of the equity market among large-, mid-, and small-cap stocks, the total number of equity funds is divided differently, more heavily weighted toward mid- and small-cap funds. Figure 5.4 shows the comparisons.

FIGURE 5.3 General Equity Funds Outperformed by Market Indexes

FIGURE 5.4 Equity Fund Composition versus Indexes*

TEN YEARS LATER

Specifically, 75 percent of the aggregate value of all equities is represented by large-cap stocks, 15 percent by mid-cap stocks, and 10 percent by small-cap stocks. The distribution of equity fund assets is almost identical. But in terms of the number of funds, the current division is 52 percent large-cap, 26 percent mid-cap, and 22 percent small-cap, a significantly larger weighting in favor of these more volatile funds. The number of funds, however, is the basis of comparison when analysts count the percentage of funds outperformed by the Standard & Poor’s 500 Index. So it follows that significant differences in annual returns will emerge as large-cap stocks lead or lag the overall market. When they lead, the success of the S&P 500 Index will be exaggerated; when they lag, the Index’s failure will be exaggerated. In the long run, however, the differences haven’t mattered. Always remember that simplistic, period-dependent comparisons—often selected to serve the interests of those making the comparisons—have the capacity to mislead unwary investors.

TEN YEARS LATER

The S&P 500 Index Is Not the Market

Despite the passage of more than a decade, the portfolio composition of equity funds remains pretty much unchanged from the earlier version of Figure 5.4, and continues to reflect the composition of the total stock market in terms of assets, although not in terms of number of funds. Since mid-1998, curiously, the annual return of the S&P 500 Index was almost identical to the return of the Wilshire 5000 Index: -0.2 percent versus 0.5 percent. (Not to say that there were not significant—one to two percentage points—variations in interim periods.) I had asked earlier: “Does it matter which index is chosen?” My answer, “In the long run, no,” was clearly on the mark.

Indexing Wins Largely Because of Cost

Given these variations between the composition of the capitalizations of the stock market (75 percent of the value of which is represented by large-cap stocks) and the number of funds in the equity fund universe (52 percent of which is represented by large-cap funds), how do we arrive at a fair basis for comparison? One simple, rudimentary way is to compare the results of the Wilshire 5000 (all-market) Equity Index with only those funds whose portfolios have weightings similar to the total market. As it turns out, mutual funds emphasizing stocks with large market capitalizations meet that standard.^l Their performance can be approximated by combining all diversified growth funds and growth-and-income funds, and excluding small-cap and aggressive growth funds. The net result is about as fair as it can possibly be: funds emphasizing large-cap stocks, but not to the exclusion of all others, and an index that also emphasizes large-cap stocks, but, again, not to the exclusion of all others.

During the past 15 years, the average return of these large-cap-oriented funds, which I’ll refer to as growth and value funds (rather than “growth and income” funds), has averaged 14.1 percent, compared to 16.0 percent for the Wilshire 5000 Equity Index. Cumulated over the period, this 1.9 percent difference, applied to an initial investment of $10,000, results in a final value of $72,600 for the average fund, a shortfall of more than $20,000 compared to the $92,700 that would have been accumulated in the Wilshire 5000 Index. (The return on the Standard & Poor’s 500 Index, a much tougher standard during that time period, averaged 17.2 percent, for a final value of $107,800.)

Only 33 of the 200 growth and value funds that survived the 15-year period outpaced the Wilshire 5000 Index during this period; the remaining 167 funds fell short. The odds of fund superiority were thus one in six. Even more interesting and, I think, more significant, is the variation of fund returns around this average. We can get some sense of the significance of the differences among funds by arraying their fund returns around the returns of the Wilshire 5000 Index, as shown in Figure 5.5.

FIGURE 5.5 Growth and Value Funds versus the Wilshire 5000 Index, 15 Years Ended June 30, 1998: Reported Net Returns (Excluding Sales Charges)*

TEN YEARS LATER FIGURE 5.5 General Equity Funds versus Wilshire 5000 Index, 25 Years Ended December 2008: Reported Net Returns*

If we adjust our thinking and agree that a spread of less than one percentage point above or below the Wilshire 5000 Index return is merely statistical noise, the odds shift: 15 funds topped the Index by more than that margin, compared to 125 funds that lost to it by the same margin. The odds of achieving that modest level of outperformance more than double: one in 13. Change the spread to three percentage points, a margin that has proven difficult for funds to achieve over the long run, and only one fund was a victor, with 43 funds among the vanquished. The odds of a given mutual fund’s providing a three-point margin above the Index were just 1 in 200. These odds give you some idea of the Herculean challenge represented by the search to select the fund’s big winners of tomorrow. (I explore this challenge more fully in Chapter 9.)

Another important lesson emerges here: The principal reason for the mutual fund shortfall is the heavy burden of fund expenses. The fund returns, relative to those of the Wilshire 5000 Equity Index shown in Figure 5.5, are calculated in the basic manner—that is, after the deduction of all mutual fund operating expenses, which are explicit (they averaged about 1.4 percent per year during this period), and portfolio transaction costs, which are implicit (during the period, they appear to have averaged at least 0.5 percent per year for these growth and value funds). The Index was cost-free, incurring neither operating expenses nor transaction costs. If we adjust each fund’s return for its approximate costs, we see a far different pattern of returns. Looking at fund returns on a gross (rather than a net) basis shifts the odds in a way that makes the industry profile look considerably better. (Fund shareholders, of course, earned only the net return.)

An examination of fund returns on a precost basis, presented in Figure 5.6, confirms the fundamental theory of indexing. Managers as a group must, by definition, provide gross returns equal to the market, just as a representative index does; therefore, the net returns earned by managers as a group will provide below-average returns once their investment costs are deducted. That result is not astonishing, nor even counterintuitive. Indeed, over the past 15 years, the 16.0 percent return on the Wilshire 5000 Index exceeded the 14.1 percent net return on the average growth and value fund by 1.9 percentage points, precisely what we might have expected based on total estimated fund costs of 1.9 percent.^m

FIGURE 5.6 Growth and Value Funds versus Wilshire 5000 Index, 15 Years Ended June 30, 1998: Gross Returns (Net Return + Expenses + 50 Basis Points)

TEN YEARS LATER FIGURE 5.6 General Equity Funds versus Wilshire 5000 Index, 25 Years Ended December 2008: Gross Returns (Net Return + Expenses + 110 Basis Points)

In Figure 5.6, we present the returns of mutual funds before expenses. We simply redraw the previous chart and adjust for each fund’s expense ratio and estimated transaction costs. In Figure 5.6, the fund distribution shifts to the right. Now, nearly half of the funds (93 of 200) outpace the Wilshire 5000 Index, and 49 do so by one percentage point or more, compared to 107 that fail to match the Index. Still not great odds, but much improved over the after-cost pattern.

When we compare these gross returns with what would be a normal distribution of results—say, based on the random results of a coin-flipping contest—something interesting, or even astonishing, happens. When we fit the dotted line in the chart against the funds’ gross returns, the result is almost perfect chance—similar to flipping a coin, albeit with the funds demonstrating a somewhat greater likelihood of falling in the middle of the distributions. Yes, one participant in 100 may flip heads 10 times in a row, but 50 participants will flip five heads and five tails. The skill of portfolio managers, then, would appear to be largely a matter of luck, a game of chance. For, as Figure 5.6 shows, relative gross returns of mutual funds have followed a random pattern. For managers in the aggregate, the heavy handicap of cost is simply too heavy to overcome.

TEN YEARS LATER

Indexing and Costs

The lesson remains: The principal reason that the returns of actively managed mutual funds fall short of the returns of the stock market is their costs. This thesis should surprise no one. After all, because of their huge importance in the market—equity mutual funds now own about 24 percent of all stocks—it is almost inevitable that they will provide the same gross return as the market. When we look at fund gross returns (by adding back fund expenses and adjusting for sales loads, where applicable), we see a pattern that resembles the random results of a coin-flipping contest, a so-called normal distribution, often known as a “random walk.” So it was a decade ago. So it remains today.

The Index Fund Is Much Better Than It Appears

To illustrate that the benefits of a passively managed index fund (compared to an actively managed mutual fund) derive largely from the costs incurred by the traditional fund, I have based the preceding illustration on the results of a cost-free market index. An actual operating index fund, though it obviously need pay no advisory fees, must incur real-world operational expenses. In fact, the lowest-cost publicly available index funds operate at annual expense ratios of less than 0.20 percent. Returns (at least for those that are operating most efficiently) should therefore run about 0.20 percent per year behind those of the target index. These efficiently managed funds have, in fact, trailed the index by some 0.20 percent annually, implying that very low portfolio turnover, combined with minimal brokerage commissions, has held transaction costs to nominal levels. To account for costs, we would reduce the 16.0 percent return presented over the past 15 years by the Wilshire 5000 Index to 15.8 percent for a Wilshire 5000 Index fund. The net return would exceed the 14.1 percent return achieved by the average managed fund by 1.7 percentage points.

Even that comparison gives managed mutual funds the benefit of a huge doubt, and, as a result, hardly gives index funds the credit they deserve. The comparison suffers from at least three distinct advantages: (1) it ignores fund sales charges; (2) it is biased in favor of funds that survive the entire period over which the comparison is made; and (3) it is not adjusted for taxes on income dividends and capital gains distributions.

Sales Charges

Virtually all presentations of industrywide mutual fund returns suffer from their failure to take into account the initial (“front-end”) sales charges, which are incurred on about 75 percent of purchases of all mutual funds, and any redemption (“back-end”) charges paid by investors who redeem their shares after relatively short-term holding periods. (About 15 percent of funds subject investors to these penalty fees; the number of investors who redeem shares early and are subject to these fees is not possible to determine.) If investors pay a 5 percent initial sales charge and hold their fund shares for five years, their return would be penalized by about 1 percent per year; if they hold the shares for 10 years, the penalty is about one-half of 1 percent per year (these amounts rise if fund returns are positive; they decline if returns are negative). Many funds are sold without sales loads, so the effective industrywide penalty on performance probably reduced fund returns from 14.1 percent to 13.6 percent, or by at least 0.50 percent annually over the past 15 years.

Survivor Bias

Survivor bias is a second significant factor in enhancing fund returns. When we look at a 15-year comparison, for example, we look at only those funds that have survived the entire period. That turns out to be quite an accomplishment, for about one-fifth of all funds that existed at the start of a typical 15-year period are no longer around at its finish. They may have simply been liquidated, or, more likely, merged into other funds in the same fund complex. But, however they vanish, it is those that have failed to deliver competitive returns that tend to disappear. Their results have been carefully measured in several academic studies. In one of the most comprehensive studies of its kind, Princeton Professor Burton Malkiel (author of the best-selling A Random Walk Down Wall Street) found that, during the 10-year period from 1982 to 1991, 18 percent of funds—59 of 331, or more than 1 of every 6—had come and gone.ⁿ During that period, the survivors enjoyed annual returns of 17.1 percent per year, but all funds together provided returns of only 15.7 percent per year. This survivor bias had therefore enhanced the annual returns reported by funds by fully 1.4 percentage points over the actual returns earned by the funds during that 10-year period. What is more, during the 15-year period ending in 1991, survivor bias accounted for an astonishing 4.2 percentage points annually. For the purpose of argument, then, let’s conservatively reduce the average fund return reported for the past 15 years by 1 percent, moving the fund return after the sales-charge adjustment, mentioned earlier, to 12.6 percent. The gap below the Wilshire 5000 Index return of 16.0 percent then grows to 3.4 percentage points.

Tax Efficiency

Another huge toll has been taken by taxes. Passively managed index funds are tax-efficient, given the low turnover implicit in the structure of the Standard & Poor’s 500 Index (and, to an even greater extent, the all-market Wilshire 5000 Index). Actively managed funds are tax-inefficient , with portfolio turnover averaging upward of 80 percent per year. In fact, during the past 15 years, the original Vanguard index fund (based on the S&P 500 Index) outpaced 94 percent of all funds on a pretax basis, but actually outpaced 97 percent of all funds on an after-tax basis. I’ll explore the matter of taxes in greater detail in Chapter 13, but based on those data, let’s assume, very conservatively, that the relative managed fund performance is reduced by another percentage point for taxable investors.

TEN YEARS LATER

Tax Efficiency

When we incorporate the results of the Vanguard 500 Index Fund since 1998 with its previous record over 15 years, we find that the fund outpaced about 68 percent of all general equity funds on a pretax basis but nearly 90 percent on an after-tax basis. Over that quarter century, the annual return of the Index Fund was 9.9 percent before taxes and 9.4 percent after taxes, both smart margins over its peers of 9.2 percent and 7.5 per cent, respectively, which total up to huge additional capital accumulations for the index investor.

The total reduction of (at least) 2.5 percentage points that is created in the real world by these three factors reduces the original managed fund annual return of 14.1 percent to 11.6 percent. The conversion of the pure Wilshire 5000 Index to include index fund operating costs, on the other hand, would reduce the return to 15.8 percent for the index fund. As far as we can tell, then, the annual spread in favor of the index fund is 4.2 percentage points per year. Whether you are a short-term, intermediate-term, or long-term investor, that shortfall truly makes a difference.

The Thorny Issue of Risk

There is a countervailing argument in favor of active managers: Equity funds fall short of the broad market index because they carry less risk. Equity funds hold cash reserves; index funds, by definition, remain fully invested and therefore are more exposed to the full force of market declines. Not only should the cash reserves held by actively managed funds in themselves lessen the shock of decline, but smart managers, recognizing that a market decline lies in prospect, can reduce stock holdings in order to raise substantial extra reserves and preserve capital.

Unfortunately for those who argue the merits of this superficially reasonable case, the record is bereft of evidence to support it. Equity fund managers, as a group, have shown no systematic ability to raise cash before major market drops or to reinvest that cash after market drops. Indeed, quite the reverse is true. Funds tend to hold large amounts of cash at market lows and small amounts at market highs. For example, funds held cash equal to only 4 percent of assets immediately before the 1973-1974 market crash, but increased it to about 12 percent at the ensuing low. Another example: At the beginning of the bull market in 1982, equity funds held cash equal to 11 percent of assets. In 1988, reserves still remained at 10 percent of assets. Yet, in mid -1998, just before the steepest stock market decline since 1987, reserves had dwindled to 4.6 percent of equity fund assets, one of the lowest mid-year totals on record. Once again, the fund managers were wrong.

But the fact is that at any of those cash levels, cash is the tail and not the dog. Simple logic compels the conclusion that a 5 to 10 percent tail cannot possibly wag the dog represented by a 90 to 95 percent equity position. Indeed, the record of funds versus market indexes in periods of market decline confirms that the portfolios composed entirely of the higher-quality, larger-cap stocks in the fully invested indexes have tended to display somewhat less volatility than the portfolios of the typical equity fund, which are composed of somewhat more aggressive stocks but seasoned with small cash positions.

On the record, index funds based on both the Standard & Poor’s 500 Index and the Wilshire 5000 Index are somewhat less risky than the average mutual fund. Morningstar Mutual Funds calculates a risk factor for each fund based on its returns in the months in which it under-performs the risk-free Treasury bill. Morningstar’s data show that, over the past decade, a typical S&P 500 Index fund was fully 15 percent less risky than the average mutual fund; over the past five years, a typical S&P 500 Index fund was 19 percent less risky, and a Wilshire 5000 Index fund was 18 percent less risky.

Looked at in a different way, the standard deviation of return over the past decade has been: S&P 500, 14.3 percent; Wilshire 5000, 14.0 percent; average U.S. diversified mutual equity fund, 14.8 percent. Conforming to the Morningstar format, then, if the standard deviation of the average fund were rated at 1.00 for the decade, the S&P 500 Index fund would be rated at 0.97, and the Wilshire 5000 Index fund at 0.95. (See Table 5.2.) Taken together, the Morningstar risk data and the relative standard deviations make it clear that, despite the fact that managed equity mutual funds do indeed maintain modest reserve positions—and have the ability to raise even more reserves in anticipation of market dips—their risk exposure has been systematically, and often significantly, greater than that of the fully invested broad market indexes.

The comparative record of managed mutual funds and market index funds in specific significant market declines confirms these data, even as it suggests that the risks carried by managed mutual funds relative to the market index funds have been rising as new, more aggressive funds have been added to the industry roster. More than a decade ago, in the largest market decline in the past generation, for example, both of the broad market indexes actually declined a bit more than the average fund. Each index fell about 29 percent during the brunt of the crash from August 31, 1987, to November 30, 1987, compared to a drop of 28 percent for the average fund. However, the Standard & Poor’s 500 Index, with a larger relative gain before the fall and a larger recovery afterward, actually rose by 5.2 percent for the year. The average fund rose by just 0.5 percent.

Table 5.2 Risk Average Equity Fund and Index Fund, Through 2008

In more recent declines, equity funds have become notably riskier. From late May through July 1996, for example, the 6.4 percent decline in an S&P 500 Index fund was 33 percent less than the 9.5 percent decline in the average fund, and the decline in an all-market index fund was 13 percent less. In the steep decline during the summer of 1998, the index funds again proved to be substantially more risk-averse, with the S&P 500 down almost 17 percent, the Wilshire 5000 down 19 percent, and the average fund down more than 20 percent. The more volatile funds formed during the late, great years of the bull market had simply made the industry more volatile. The leopard had changed its spots—but at the wrong time.

If we examine the record, using the various Morningstar-style categories of equity funds (large-cap value, small-cap growth, and so on), we find a highly consistent pattern of higher risk relative to comparable market indexes (not merely the S&P 500 Index) throughout the entire matrix. Risks assumed by funds have been particularly large among the various small-cap categories relative to comparable small-cap indexes. The net result is that index fund risk-adjusted returns have carried an even higher margin of advantage over actively managed funds than the raw (unadjusted) returns indicate. The style categories and these relationships are more fully described in the final pages of Chapter 6.

In all, it’s hard to imagine why the specter of high risk continues to haunt the image of index funds. They decline precisely in step with the markets they measure. But so do managed funds—and even more markedly in recent years, as the industry has come to include more aggressive funds. The record simply doesn’t support the premise that the modest positions in cash reserves held by actively managed funds provide an anchor to windward, nor the assertion that smart, agile portfolio managers systematically anticipate market declines and take defensive action. With fund cash reserves that were 50 percent lower at recent market highs than they were in the depressed markets of the early 1990s, quite the reverse appears to be true.

TEN YEARS LATER

Risk

One of the most remarkable reflections on the obvious triumph of indexing is the fact that the broad market indexes bear substantially lower risks than equity funds as a group. In the past five years, in fact, index fund risk as measured by Morningstar was more than 30 percent below the risks assumed by actively managed funds. Ten-year standard deviations of index funds were also substantially lower (16 percent versus nearly 20 per cent). These data, shown in Table 5.2, reflect a far larger assumption of risk by active funds than in the table and discussion in the previous edition. While index funds were hit hard after the technology stock bubble of the late 1990s, they had significantly smaller losses in the aftermath of the financial stock bubble that burst in the autumn of 2008.

All Index Funds Are Not Created Equal

In this analysis of market indexes and index mutual funds, I have had to rely largely on the records of the original two index funds simply because, as the pioneers in the field, they are the funds with the longest records (23 years for the Vanguard 500 Index Fund, and seven years for the Total Stock Market Index Fund). But a caution is necessary: Both of these index funds are large; both are free of sales loads; both have operated at rock-bottom cost; both have maintained low portfolio turnover; and both have been administered with extraordinary efficiency, enabling them to track their target indexes with considerable precision.

The same cannot be said about all of the index funds that are now available in the marketplace. Of some 140 index funds, about 55 are modeled on the S&P 500 Index; four on the Wilshire 5000 Index; 46 on subsets of the overall U.S. stock market (large-cap growth and value, small-cap growth and value, and so on); 18 on international markets; and just 20 on the U.S. bond market. Instead of blindly choosing an index fund, investors must be careful to determine that the fund they select is indexed to the market segment they wish to emulate.

Surprisingly, one-third of all index funds carry either front-end or asset-based sales charges. Why an investor would opt to pay a commission on an index fund when a substantially identical fund is available without a commission remains a mystery. The investor who does so starts out on day one by falling as much as 5 percent or more behind the target index—behind the eight ball, as it were—and falls further behind each year, as fund expenses take their toll. Suffice it to say that it would be silly for an intelligent investor to select an index fund that carries a commission.

It is equally nonsensical to select a fund that carries a high operating cost. Annual expense ratios of index mutual funds run from as low as a nominal 0.02 percent for funds available to very large institutional investors, and 0.18 percent for publicly available funds, to as high as 0.95 percent, the rate charged by at least one established fund. That is simply too much to pay. (When a representative of that fund was asked how such a confiscatory fee could be justified, he responded, “It’s a cash cow.” For the manager, indeed it is. But a cash cow for the investor is a better option.)

Further, beware of the many funds that attest that their expense ratios are low, stating only in the fine print that fees are being waived for a temporary period or until a specific future date. What, really, is the point in your paying an artificially low expense ratio of, say, 0.19 percent for a few years, after which a much higher 0.50 percent fee may be assessed? It is at least possible that, by that time, your investment will have appreciated in value, and you will be subject to capital gains taxes that outweigh the obvious advantage of shifting to a truly low - cost fund. Be sure to read all the fine print about costs in the advertisements, and pay careful heed to the details in the fund’s prospectus.

Next, there is the question of portfolio turnover. One of the great advantages of index funds is their tax efficiency. But some index funds, either because of constant heavy investor activity or because of portfolio strategies based on the aggressive use of index futures, generate high portfolio turnover—sometimes as much as 100 percent or even more—and consequently realize and distribute substantial capital gains. When tax-efficient index funds abound, there is simply no reason for taxable investors to select index funds that are tax-inefficient.

Further, all index funds are not created equal in operating efficiency. Some index fund managers, whether by virtue of skill, experience, or dedication, simply do a better job than others in the execution of portfolio transactions. Taking 1996 through 1998 as an example, the best managers of the Standard & Poor’s 500 Index funds were actually able to outpace the returns of the index itself by as much as

of 1 percent annually before the deduction of operating costs; the least successful managers fell

of 1 percent (or more) behind. This difference in ability to match the index is pretty much ignored by the marketplace. But it should not be. Of what value is a manager, for example, who brags about an expense ratio (often temporary) of 0.18 percent and loses 0.30 percent in operating margin, resulting in a net shortfall of 0.48 percent to the index? Compare those results to the performance of a manager who charges 0.20 percent and exactly matches the index return, for a net shortfall of 0.20 percent. Investors should carefully examine the aspects of each manager’s implementation of strategy for any index fund that is being considered.

Finally, index funds vary in the amount of unrealized capital gains in their portfolios. In the abstract, those with modest appreciation (or even losses) on their books might be favored over those with very large appreciation. But this factor should be weighed only in light of the countervailing advantages the funds may offer, as well as their susceptibility to heavy redemptions, their election of redemption-in-kind policies (thus obviating the need to liquidate portfolio securities), and their tax management strategies.

None of these little percentages may seem like much, but they can represent the difference between day and night for the long-term index fund investor. Even tiny differences in returns truly matter in a lifetime investment program. Consider the different approaches to index fund selection given in Table 5.3. After a decade, $10,000 in the no-load, low-cost, efficient index fund would have grown to $30,500; in the worst outcome, the load, high-cost, inefficient fund would have grown to $26,500.

TABLE 5.3 Net Returns of Index Funds with Varying Characteristics

Such a hypothetical example is hardly absurd. It is real. Over the past decade, $10,000 invested in one efficient, low-cost, no-load S&P 500 Index fund would have grown to $54,000. Another putatively identical, but less efficient, higher-cost index fund carrying a 4.5 percent load would have grown to only $47,000—truly a staggering gap between two S&P Index funds with the same portfolios. (This latter fund, as it happens, was the “cash cow” described earlier.) All index funds are not created equal.

Indexing Works in All Markets

That index funds are finally achieving grudging acceptance bears witness to the great success that index funds modeled on the Standard & Poor’s 500 Stock Index have enjoyed by providing, in an era of extraordinary absolute stock market returns, superior relative returns as well. In addition, the all-market index fund, modeled on the Wilshire 5000 Equity Index, is beginning to make competitive inroads as it brings to full fruition the essential theory of indexing: that all investors, as a group, cannot possibly outpace the total (cost-free) return on the entire stock market. But the remaining detractors of index funds still hold to the position that indexing works only in efficient markets, such as those represented by the actively traded, very liquid large-capitalization stocks that overpoweringly dominate the S&P 500 Index and comprise 75 percent of the Wilshire 5000—and not in other presumably less efficient markets.

Plausible as that argument may sound, it is specious. The success of indexing is based not necessarily on some notion of market efficiency, but simply on the inability of all investors in any discrete market or market segment to outpace the universe of investments in which they operate. Efficiency relates to a market price structure that generally values all securities properly at any one time, which means that good and bad managers alike will have difficulty in differentiating themselves either way. In inefficient markets, good managers may have greater opportunities to outpace their universe. But the excess returns earned by good managers must inevitably be offset by inferior returns of the exact same dimension by bad managers.

However, costs of funds operating in so-called inefficient markets are higher than funds operating in efficient markets. For example, costs of U.S. small-cap funds are systematically higher than those of large-cap funds. In Chapter 6, we will see that once the relatively higher risks that they assume are accounted for, managed mid-cap and small-cap funds have realized similar (if slightly larger) shortfalls to the indexes in their market sectors, compared to those their large-cap cousins have realized.

Costs of international funds are higher still, not only because of their higher expense ratios but because of much higher custodial costs, taxes, commissions, and market impact costs. As a result, not only do the exact same principles of indexing apply in international markets, but an even larger margin of index superiority is reflected in passively managed international index funds, compared to actively managed international funds, as will be shown in Chapter 8. Indexing works—as it must—with high effectiveness in all the far-flung corners of the world of equity investing.

Table 5.4 illustrates how the total relationship between manager returns and index returns in efficient and inefficient markets might work. Note how the symmetrical pattern of precost returns quickly becomes asymmetrical after the deduction of costs. Put another way, the onus of costs erodes the superiority of the top equity managers, even as it magnifies the deficiency of the bottom-tier managers. But it does so by larger amounts in inefficient stock markets. Ironically, then, equity indexing should work better in inefficient markets than in efficient markets.

Indexing works in the bond market, too. Indeed, it is arguably even more valuable where high-grade fixed-income investments are concerned. Bond returns are typically lower than stock returns, so costs take a large toll on the gross annual returns earned by bond funds. The gross returns of competing bond funds tend to be similar, but the costs of most bond funds, as I will note in Chapter 7, are excessive, giving low-cost bond index funds a remarkable head start. Finally, successful managers who achieve substantial superiority in precost returns are conspicuous by their paucity. There are, apparently, few Peter Lynches in the bond fund field. There are good managers and bad managers, as always, but no heroes who tower above all others.

The average bond fund has turned in an average annual return of 8.7 percent over the past 15 years, compared to 10.2 percent for the Lehman Aggregate (U.S.) Bond Index. That shortfall of 1.5 percentage points is largely accounted for by the estimated 1.3 percent annual expense incurred by the average bond fund (expense ratio of 1.08 percent plus portfolio transaction costs of perhaps 0.25 percent). Over a different time period, the first bond index fund, formed in 1986, has reflected a similar pattern of superior performance. Since its inception, its annual return has averaged 8.1 percent (net of operating expenses averaging about 0.20 percent and transaction costs of 0.10 percent). Its margin of superiority over the 7.4 percent return of the average bond mutual fund during the same period represents a 9 percent enhancement in returns over professionally managed bond funds. Chapter 7 will demonstrate how that same pattern of index superiority shines through in every major segment of the bond market—total, long-term, intermediate-term, taxable, and tax-exempt bonds alike. The success of indexing is not only theoretical; it is pragmatic. We must find it everywhere, and we do.

TABLE 5.4 Manager Returns versus Market