The Value of Asset Allocation: A Case for Indexing

Large cap stocks or mutual funds are core to any portfolio. Allocations to this asset class range from 15% to 35% depending on risk tolerance. (If you have more than this, you may want to evaluate your portfolio!) Most of us have seen the articles featured in the Wall Street Journal where a chimpanzee throwing darts at a stock page tends to outperform Wall Street’s brightest managers. Over the past 20 years there have been numerous studies on the value of selecting managed mutual funds vs. simply buying an index fund.

An index fund is mutual fund designed to mimic the returns of a given stock market index such as the S& P 500. For example, the Schwab Institutional S & P 500 Index fund simply utilizes a computer model to purchase all of the US’s largest 500 stocks in a weighting equal to their market cap.

According to a recent article in the Journal of Financial Planning by Thomas P. McGuigan, CFP, the large cap fund index (S& P 500) outperformed managed mutual funds 72% to 84% of the time over rolling 5,10, 15 and 20 year periods since 1993. The study concluded that the longer the period of time, the more likely the index beat the managed funds. The percentage of mutual funds that outpaced the index fund was only 10.59%. Thus, only 18 of 171 mutual funds outperformed the index fund over 20 years. The majority of out performers, 12 out of 18, only outperformed by 1% or less. This study did not take into account all the funds that are no longer in existence. If this figure was included, the percentage of funds that beat the index would be even lower. The study also found that the cost of selecting the wrong fund was very high.

The majority of the underperformers (113 funds), missed the mark by 1 percent or more. In my opinion, these odds are just not worth the risk.

Why is it that a chimp can outperform a manager in large cap stock selection? The answer lies in market efficiency, managed fund expenses and taxes. The US stock market and particularly the large cap stocks are nearly perfectly efficient. This means that the markets impound information into prices so well that the analysis of publicly available information will not produce excess returns. Thus manager out performance is simply luck rather than skill.

In addition to market efficiency, fund costs have a huge impact on performance. Fund costs include expense ratios, commissions, bid ask spreads and impact costs. Expense ratios are the cost of staff and overhead. Commissions and bid ask spreads are the actual costs of trading stocks. Impact costs relate to the expense associated with liquidating a large position in a particular stock. These expenses range form 1 to 2 percent per year for all funds.

On the other hand, an index fund has considerable lower expenses. For example, the Schwab Institutional S &P 500 Index fund mentioned above has a total expense ratio of just .22%. This gives the index fund a considerable advantage over its peers. Not only do managed funds have to beat the index, they must also cover their expenses. If the case above for indexing is not powerful enough, consider the impact of taxes. Managed portfolios generate nearly twice as much tax liability as index funds.

If all of the hold true for large cap stocks, what about smaller cap funds and international funds? While fund costs for these asset classes are actually higher, markets are less efficient giving some managers the edge. I generally used index funds for large cap portfolios and best in class institutional money managers for other asset classes.