Why Index Funds Can't Be Beat

For typical investors, managed mutual funds have never made much sense. Now that scandal has struck, they make even less

By Christopher Farrell

I wanted to share excerpts from a handful of e-mail I've received recently on the mutual-fund scandal. A lot of individual investors are understandably worried, as the rogues' gallery of miscreants accused of allowing illegal and improper trading in their funds grows. Here's what readers have to say:

"I'm not rich or famous -- though I'm concerned about becoming poor...."

"I'm invested in five different Strong Funds equaling $65,000, and am wondering if I should sell while there's still a balance left in the funds -- even though some would be sold at a loss.... I'm trying not to panic."

"Large investors are pulling their money from Putnam. What happens to the little guys who are left holding the bag? Their dreams of retirement will go up in smoke."

"I'm involved in our 401(k) employee committee. I was wondering if it would be appropriate, and worthwhile, to ask the managers of the mutual funds in our 401(k) to send a letter stating that, to their knowledge, they have not engaged in any of the actions currently under investigation in other funds?"

"In view of the recent problems with Putnam funds, what would you recommend an investor do? I have these funds invested as an IRA in small caps, midcaps, and government bonds.... I'm 61 years and 4 months old. I would like to retire at age 62 and 3 months. Should I weather the storm or look for somewhere else to invest?"


  These concerns are valid, given the list of brand-name mutual funds already drawn into the widening scandal: Janus, Nations Bank, Bank of America (BAC ), Strong, Alliance, Putnam, Prudential, and Alger. And all indications are that more top-drawer mutual-fund companies will be accused in coming weeks of breaching their fiduciary responsibilities. This scandal is proof of Wall Street's infamous cockroach theory: If one "bad news" cockroach is revealed, chances are many more are scurrying right behind.

The scandal is especially galling because many people have invested in mutual funds through necessity not choice. Beginning in the 1980s, many companies retreated from offering their workers expensive traditional "defined benefit" pension plans in favor of low-cost "defined contribution" plans, such as 401(k)s.

The numbers are breathtaking. At yearend 2002, mutual funds accounted for 21% of the more than $10 trillion U.S. retirement market. An additional $20 billion has been invested in over 3 million accounts in college savings plans, the state-sponsored 529 plans, and the Coverdale (formerly known as the education IRA).


  So what's the individual investor to do? Truth is, many don't have a lot of attractive choices other than mutual funds when it comes to saving for retirement, children's college education, and other long-term goals. Still, I would consider transferring money out of actively managed mutual funds and investing it in index funds. After all, most professional mutual-fund money managers weren't worth their huge salaries -- and that's before considering the scandal's impact.

Most of these pros fail to beat the market with any consistency. The benchmark Standard & Poor's 500-stock index outperformed 84% of actively managed large-capitalization equity funds over the past 10 years and 88% over the last 20 years, according to Burton Malkiel, a finance professor at Princeton University and author of the best-seller, A Random Walk Down Wall Street.

What's more, actively managed mutual funds take too much of an investor's hard-earned savings. Yes, I know investors are being reassured that the losses absorbed by any one person are small, perhaps no more than 1% on a $10,000 investment over the course of a year. That cost calculation of abuse may be right. But the impact on the average mutual-fund investor is much greater.


  The cost of owning actively managed mutual funds is too steep to begin with. Taking into account high turnover costs, sales charges, and other expenses, it averages close to 3% a year. John Bogle, the founder of the giant mutual-fund company Vanguard and an industry gadfly, estimates that during the 1984-02 period the average mutual fund returned slightly over 9%, vs. a 12% annual return for the S&P 500.

The outrage is that some mutual-fund companies have decided to add another "fee" -- that 1% nick for allowing hedge funds and other gunslingers to profit at the expense of long-term owners. Once again, they're cutting into the returns actually earned by mutual-fund investors. What a deal!

Broad-based equity index mutual funds are the way to go for most individuals. So are exchange traded funds (ETFs), index funds that trade on the major stock exchanges. Index funds are simple. Fees are razor thin. Trading costs are minimal.


  And people seem to have forgotten how incredibly efficient the stock market is. Phenomenal sums change hands every day, as millions and millions of very smart people (and many more not-so-smart ones) try to get an edge on the competition. What moves stock prices is new information, which by definition is unpredictable. As Rex Sinquefield, chairman and chief investment officer at Dimensional Fund Advisors, once put it: "There are three classes of people who do not believe that markets work: the Cubans, the North Koreans, and active managers."

In the short run, keep cool, especially if your mutual-fund company hasn't yet been caught up in the scandal. For those investors who have been duped, it may make sense to get out.

But no one should transfer funds before doing quite a bit of homework. Are there any exit fees? What about tax consequences? Where will you put the money? Is now the time to exit the market altogether? Plus, as Morningstar notes, "The industry is being forced to clean up its act, meaning that funds are apt to be better regulated and more shareholder-friendly in the future than they are right now."

One of the great debates on Wall Street over the past several decades has been between the proponents of professional money managers and the advocates of indexing. The Great Wall Street scandal of 2003 is simply one more reason why indexing pays. At this point, shareholders can use all the help they can get.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Edited by Beth Belton

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