Is Index Investing or Active Management better?
By Joseph T. Chadwick

It’s a common question among mutual fund investors: Is it “better” to invest in index funds or actively managed funds? While frequently debated, it is never resolved. Part of the problem is the question itself. What is a market index and what does it mean? Which index are we talking about and what does that particular index represent? What period of time are we talking about? How frequently and how consistently must an index win the performance race in order to settle the question? A look at the S&P 500 index and one year time frames is illustrative.

The basics
There are indexes for almost every market segment and style of investing. Let’s take a look at one. The S&P Index is generally considered to be the best reflection of “average” U.S. stock market results. It includes companies from each major economic sector. The companies are selected by Standard and Poor’s to be generally representative and viable organizations. The index is weighted by the market value of the companies so the biggest companies e.g., General Electric, Exxon, Microsoft, account for a large percentage of the results. The companies in the index don’t change very much year to year. It is considered a good “benchmark” against which to judge the performance of managers of large company, diversified stock funds.

Now let’s look at two actively managed funds. The Legg Mason Value Trust is considered a large company, diversified stock fund. The year 2006 marked the end of its unique 15 year streak of annually beating the S&P 500. The next longest streak was Quaker Strategic Growth Fund with only eight consecutive years. It too failed to beat the S&P 500 last year. Only seven diversified large company funds which, if they make it through 2007, have a chance to equal the Quaker Fund record. It is undeniably very difficult to “beat the market” consistently each year – even if only by a tiny amount. In fact, The Wall Street Journal in January reported that only 19% of all actively managed US diversified stock funds had out-performed the S&P 500 with just two days remaining in 2006.

Those who advocate active management funds would take great umbrage if this anecdote pretended to resolve the indexing vs. active management story. The Legg Mason Value Trust and Quaker Strategic Growth compiled cumulative long term records that greatly exceeded the cumulative performance of the index, including the one year failure to outperform the S&P 500. But many other funds neither outperformed the S&P in 2006 nor over the long term.

Is there a right answer?
So, where does all this leave the investor? We think it is more useful to consider the inherent benefits of index investing and just decide if it makes a lot of sense for some or all of an investor’s portfolio.

Let’s turn back to the nature of a market index. Institutional investors dominate stock and bond trading and basically determine the prices. This determines the results of a market index. This is not collusion. They compete with each other. For every buyer who thinks it’s the right price to pay to own the stock, there is a seller who thinks it’s the right price to get rid of it and invest in something more attractive. Basically, by buying, holding and selling the market average, you are making investment transactions based on the best judgment of the smartest and most focused managers in competition with each other. You won’t be in one of the “winners” and you won’t be in one of the “losers” but you will be consistently experiencing the average of the professionals.

Paradoxically, you can do this at a lower cost than hiring all those managers directly. The cost of investing in index funds is significantly lower than investing through actively managed funds. Unlike the index vs. active debate; you will find little serious disagreement here. When you buy index funds you get the average judgment of the professional managers at a fraction of the cost. The logic is pretty compelling unless you have a strong conviction that you can select the active managers who are going to outperform the index over whatever period is important to you.

The importance of diversification
Once you have made the decision to index your assets, your remaining focus is only on asset allocation and keeping your portfolio in alignment with your strategic targets. That element of investment is actually much more important than the method of management or the selection of specific managers. The academic literature says it accounts for more than 90% of the difference in results. The major index products are just that – diversified portfolios of various classes of assets.
The debate over indexing versus active management will never end. There are too many variables and too many exceptions to the general rules to end the discussion with a simple conclusion that indexing is superior in all cases. On the other hand, in almost all reasonable time frames, indexing is a strategy that will consistently deliver competitive performance at a low cost. That seems to be a good way for all investors to manage part, if not all, of their money. It may even be the best way for most.

Joseph T. Chadwick is an independent financial and investment consultant. Before establishing his own firm, he headed an investment consulting practice with Mercer Consulting and was an executive with Vanguard Group and T. Rowe Price. He is currently working with Longevity Alliance in developing its investment program.