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FPA Journal - Indexing Versus Active Mutual Fund Management

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  • 1. FPA Journal - Indexing Versus Active Mutual Fund Management Indexing Versus Active Mutual Fund Management The purpose of this paper is to examine the benefits of active mutual fund management investing versus index funds. In general, we find that index funds outperform actively managed funds for most equity and all bond fund categories on both a total return and after-tax total return basis, with the exception of actively managed Small Company Equity (SCE) and International Stock (IS) funds. These results should be viewed with caution, however, as there is evidence that actively managed funds outperform the index funds during periods when the economy is either going into or out of a recession. by Rich Fortin, Ph.D., and Stuart Michelson, Ph.D. Rich Fortin, Ph.D., is a professor of finance at New Mexico State University in Las Cruces, New Mexico. He has written articles for the Journal of Financial and Quantitative Analysis; Journal of Financial Research; Journal of Investing; Journal of Financial Planning; Financial Analysts Journal; and the Journal of Small Business Finance. Stuart Michelson, Ph.D., is the Roland & Sarah George Professor of Finance at Stetson University in DeLand, Florida. He has written articles for the Journal of Business, Finance, and Accounting; Financial Services Review; Journal of Investing; Journal of Financial Planning; British Accounting Review; and the Journal of Financial Education. This paper examines the benefits of active mutual fund management versus investing in index funds. Do actively managed funds perform well enough to overcome the cost and tax disadvantages? This study is an update and extension of a prior paper by Fortin and Michelson (1999) in that a more recent and longer time period is covered, and comparisons are made across investment categories, and over time, to actual index funds rather than market indexes. An after-tax return comparison is added to the analysis. There has been a longstanding discussion over the relative benefits of active versus passive management in the mutual fund literature. On the one hand, the very fact that we have thousands of investment professionals involved in active mutual fund management suggests that there must be benefits accruing to supposedly rational investors in these funds. For example, Elton, Gruber and Blake (1996) show that their portfolio of high-alpha actively managed funds outperformed the Vanguard S&P Index fund from 1981 to 1993. Lowenstein (1997) debates whether indexing is affecting underlying stock prices. He indicates that there may be a premium for stocks that are added to the S&P 500 and that the very nature of indexing creates overvaluation of indexed stocks. Wermers (2000) finds that equity mutual funds outperform the market by 1.3 percent per year, although expenses and transaction costs reduce this benefit to essentially zero. His conclusion: "Funds pick stocks well enough to cover their costs." On the other hand, both recent and long-term evidence points to the advantages of indexing over active management. Elton, Gruber and Blake (1996) ask the relevant question: "Given that there are sufficient index funds to span most investors’ risk choices, that the index funds are available at a low cost, and that the low cost of index funds means that a combination of index funds is likely to outperform an active fund of similar risk…why select an actively managed fund?" Bogle (2000) illustrates that an index fund has a 350-basis-point advantage over the average equity mutual fund due to management expenses, brokerage costs, sales charges and tax advantages. Arnott, Berkin and Ye (2000) find that the Vanguard 500 Index fund outperforms the average equity mutual fund and the effect is amplified when taxes are considered. Malkiel (1996) notes that over the past 25 years, about 70 percent of active equity managers have been outperformed by the S&P 500 Stock Index. Gruber (1996) and Bogle (1995) also find similar results. They argue that index funds allow investors to buy securities of many different types with minimal expense and significant tax savings. Bogle (1996) states that "the case for selecting an index fund is compelling due to indexing’s inherent cost advantage." Malkiel (1995) concludes by stating that "most investors would be considerably better off by purchasing a low expense index fund than by trying to select an active fund manager who appears to possess a hot hand." 2002_Issues/jfp0902 (1 of 11)
  • 2. FPA Journal - Indexing Versus Active Mutual Fund Management This study tests the hypothesis that actively managed mutual funds have significantly outperformed (underperformed) index funds over the study period, 1976–2000. We perform this investigation using both total returns and after-tax total returns, which has not been done previously. This study examines eight classes of mutual fund categories, including multiple categories of equity funds and bond funds. Previous research primarily examined smaller samples and time periods of equity funds on only a before-tax basis. Data The mutual fund data used in this study came from the January 2001 Morningstar Principia Pro Plus for Mutual Funds. This database contains historical information on virtually the entire universe of mutual funds through the December 31, 2000, year-end. The funds are classified by investment objective, and total return, income and capital gain distributions, annual expense ratios, fund size and turnover information are provided for each of the funds along with a wealth of other fund data such as load status. There are over 12,000 funds included in this database, which is one of the most widely used research sources for mutual fund information. This study groups the funds into eight broad investment categories: Aggressive Growth & Growth (AGG), Growth/ Income & Equity/Income (GIEI), Specialty Equity (SP), Small Company Equity (SCE), Corporate Bond (CB), Government Bond (GB), International Stock (IS) and Asset Allocation & Balanced (AAB). The comparison index funds include Vanguard Index 500, Vanguard Total Bond Index, Vanguard Small Cap Index, Vanguard Total International Index and Vanguard Balanced Index. These index funds were selected because of their more complete return series over the study period and the fact that the Vanguard Group pioneered index investing over 25 years ago. The final sample contains 9,329 funds with 46,540 annual return data points.1 The actively managed fund categories were matched with index funds that most closely approximated the investment objective of the funds. A consideration in the selection of the comparison index fund was that the index fund had a return series long enough to perform statistical tests. The funds were matched as follows. The Aggressive Growth & Growth, Growth/Income & Equity/Income and Specialty Equity funds were matched with the Vanguard Index 500 fund. Small Company Equity funds were matched with the Vanguard Small Cap Index fund. The Corporate Bond and Government Bond funds were matched with the Vanguard Total Bond Index fund. The International Stock funds were matched with the Vanguard Total International Index fund. The Asset Allocation & Balanced funds were matched with the Vanguard Balanced Index fund.2 Results also were computed for the Vanguard Total Stock Index fund and Vanguard Extended Market Index fund, but because the return series for these funds were much shorter, the results are not presented in this paper. Methodology The methodology employed to test the hypothesis of significant differences in mutual fund returns involve a comparison of the cross-sectional mean (median) mutual fund returns each year and over the 25-year period. These tests are performed across investment classifications. The returns relationship is investigated by segmenting the sample by fund category and testing the mean (median) differences in fund returns between the index funds and each category. Both parametric and non-parametric statistical tests are used where applicable. Tests are performed on both a before- and after-tax basis. (A parametric test is a statistical test of significance primarily used for larger samples that are normally distributed. A nonparametric test is a statistical test of significance primarily used for smaller samples, without the restriction that the sample be normally distributed.) Because annual total returns (calculated assuming reinvestment of all dividends and capital-gain distributions) are provided by Morningstar, the critical variable to be computed is the after-tax total return. This calculation involved estimating the historical marginal tax rates on ordinary income and capital gains. This paper uses the marginal tax rates provided in Exhibit 1 of Siegel and Montgomery [Winter 1995]. Because tax rates are heterogeneous, they chose an arbitrary single taxpayer earning $75,000 in "earned" (noninvestment) income in 1989 dollars. This level of income was deflated (inflated) by the Consumer Price Index (CPI) for earlier (later) years. They argue that this investor would be typical of individuals with sizable investment portfolios subject to tax. Because our data starts in 1976, we use the Siegel and Montgomery marginal tax rates on ordinary income and capital gains from 1976 through the end of their study in 1993. For the years 1994 through 2000, we use tax code information on the ordinary income and capital gains rates and adjust earned income by the CPI for each year. After-tax returns for a given mutual fund in 2002_Issues/jfp0902 (2 of 11)
  • 3. FPA Journal - Indexing Versus Active Mutual Fund Management a given year are computed by adjusting the total return for the taxes that would have been paid on the dollar income and capital-gain distributions for that year.3 There is a slight upward bias in this after-tax return computation because Morningstar includes both short-term and long-term capital gains in its yearly dollar-per- share capital-gain figure. The short-term capital-gain distributions should be subject to the higher ordinary income-tax rates, but it was not possible to make this adjustment. Consequently, the differences between before- and after-tax returns presented in this article are slightly smaller than would actually be expected. Empirical Results Table 1A provides summary descriptive statistics for each of the eight investment categories and Table 1B provides similar information for the five comparison index funds. The expense ratio is the total fund expenses expressed as a percentage of fund assets. Total fund expenses include all management and administrative fees, 12b-1 distribution fees, and all other asset-based costs incurred by the fund, except brokerage costs. Sales charges (front or deferred loads) are not included in the expense ratio. Fund size is the total net assets of the fund (in millions of dollars). Turnover, as defined by the Securities and Exchange Commission (SEC), is computed by taking the lesser of purchases or sales (excluding all securities with maturities of less than one year) as a percentage of average fund assets. Return is the yearly total return computed based upon changes in fund net asset value (NAV) assuming reinvestment of all income and capital gain distributions. Returns are net of the funds expense ratio and brokerage costs, but are not adjusted for front or deferred loads. The number of observations (N) is the total number of non- missing observations for each variable. N is often different for the five variables because data is missing in the Morningstar database more often for some variables than others. In Table 1B, the number of observations for the Vanguard Index 500 total return variable is 24, while it is 25 for the Vanguard Small Cap Index. This is because our analysis started in 1976 and Morningstar reported a total return for the Vanguard Small Cap Index for this year but did not do so for the Vanguard Index 500 until 1977. The number of observations is the same for both indexes for after- tax total returns because the lagged prior year net asset value is required to make this computation. 2002_Issues/jfp0902 (3 of 11)
  • 4. FPA Journal - Indexing Versus Active Mutual Fund Management 2002_Issues/jfp0902 (4 of 11)
  • 5. FPA Journal - Indexing Versus Active Mutual Fund Management Tables 1A and 1B provide a broad overview of the total return, after-tax total return, turnover, expense ratio and size variables for the funds across investment classifications. The second column of Table 1A provides the comparison index fund for each category and the years used for the analysis. Notice that each of the category comparison periods is different due to differing lives of the respective index funds, so the following discussion should be read with that in mind. For example, the Vanguard Index 500 has 24 comparison years because the fund was started in 1976 and Morningstar reports its first full year return in 1977, while the Vanguard Total International Index fund has been in existence for only four full years. Continuing with Table 1A, the total return/after-tax total return was highest for the equity funds and lowest for the bond funds. The Aggressive Growth & Growth (16.86% / 14.80%) and Small Company Equity (16.47% / 14.65%) funds were the leading equity funds. The lowest total return category was Corporate Bond funds (6.48% / 4.16%). For the comparison index funds, the Vanguard Index 500 fund (15.52% / 13.58%) had the highest total return. The Vanguard Total International Index fund (7.28% / 6.70%) and the Vanguard Total Bond Index fund (7.93% / 5.52%) had the lowest total returns. Growth/Income & Equity/Income funds had the lowest turnover (68.05 percent), while Government Bond funds (170 percent) and Specialty Equity funds (126.05 percent) had the highest turnover. As anticipated, the index funds had lower turnover ratios than their comparison fund categories. The Vanguard Small Cap Index fund (70.33 percent) had the highest turnover, while the Vanguard Total International Index fund (3.00 percent) had the lowest turnover. Unexpectedly, the Vanguard Total Bond Index fund (42.23 percent) had a relatively higher turnover. Expense ratios were highest for International Stock funds (1.89 percent) and Specialty Equity funds (1.65 percent) and lowest for Government Bond funds (1.02 percent). As expected, the comparison index funds had, overall, lower expense ratios. The Vanguard Small Cap Index fund (0.82 percent) had the highest expense ratio and the Vanguard 2002_Issues/jfp0902 (5 of 11)
  • 6. FPA Journal - Indexing Versus Active Mutual Fund Management Total Bond Index fund (0.20 percent) and the Vanguard Balanced Index fund (0.20 percent) had the lowest expense ratios. The largest funds were Growth/Income & Equity/Income ($640.26 million) and Aggressive Growth & Growth ($503.50 million). The smallest category was Small Company Equity funds ($206.16 million). The index funds were generally much larger than their peer comparison funds. The largest index fund was the Vanguard Index 500 ($16,731.37 million) and the smallest was the Vanguard Small Cap Index fund ($677.02 million). Table 2 presents the paired comparison t-tests for total return (left panel) and after-tax total return (right panel) for each of the eight fund categories overall, with respect to their comparison index funds. We take the index fund return minus the active fund return and then compute a paired comparison t-test based upon this value. Therefore, a positive mean return indicates that the index fund outperformed the average actively managed fund. The statistical results performed on the differences in returns appear to reflect skewed distributions when comparing the mean and median returns values. We, therefore, compute the nonparametric sign test to determine if there is a significant difference in the number positive versus negative differences in returns (Index minus Active fund). 2002_Issues/jfp0902 (6 of 11)
  • 7. FPA Journal - Indexing Versus Active Mutual Fund Management All fund categories, except Specialty Equity funds, showed a significant difference in returns (at the .0001 level) between the index funds and the actively managed funds for total return. Interestingly, three equity categories exhibit a negative relationship for total return (and two categories for after-tax total return), indicating that the actively managed funds significantly outperformed the index funds over the full comparison period. The Aggressive Growth & Growth (total return only), Small Company Equity and International Stock funds exhibited this negative relationship (note that the IS funds only contained four years of data). After-tax total returns exhibited similar relationships, except that the AGG funds were not significant (and positive), instead of significantly negative. The nonparametric sign test provides a stronger indication of these results. All categories, except two (Small Company Equity and International Stock funds), show significantly more positive than negative returns (based on a one-tailed test at the 0.0001 level) for both total return and after-tax total return. The nonparametric results provide additional evidence that index funds outperform actively managed funds for all categories, except for SCE and IS funds. Tables 3A and 3B present the results of the same paired comparison t-test for each of the eight fund categories on a year-by-year basis for total return and after-tax total return. Note that the SCE comparison starts in 1977 rather than 1976 to simplify the table. Over all categories and time periods, 113 out of 136 differences in total returns and 110 out of 136 after-tax total returns are significant. Table 4 shows how many total returns are significantly positive (index fund outperforms) versus significantly negative (actively managed fund outperforms). 2002_Issues/jfp0902 (7 of 11)
  • 8. FPA Journal - Indexing Versus Active Mutual Fund Management 2002_Issues/jfp0902 (8 of 11)
  • 9. FPA Journal - Indexing Versus Active Mutual Fund Management Five of the eight total return categories show that index funds outperformed actively managed funds in the majority of years (the IS category was split), while active management outperformed indexing in the majority of years in two categories (SCE and CB). These results were similar for after-tax returns except for the AGG category. This summary reinforces the conclusion that Small Company Equity funds outperform the index funds whether considering total returns or after-tax total returns. Fortin and Michelson (1999) also found similar total return results for Small Company Equity funds. The results for the International Stock funds were split (two positive and two negative) on both a before- and after-tax basis, although overall in Table 2, active management outperformed on both a pre-tax and after-tax basis. The International Stock fund results should be viewed with caution given the relatively short time periods involved. 2002_Issues/jfp0902 (9 of 11)
  • 10. FPA Journal - Indexing Versus Active Mutual Fund Management In addition, it appears that the results in Table 3 are sensitive to the business cycle. The managed funds seem to outperform the index funds during periods when the economy is either going into or out of a recession. There are negative values of differences in returns (index return minus active fund return) fairly consistently during 1979–82, 1991–93 and 1999–2000. It appears that active fund management is better than investing in index funds when guiding portfolios through difficult times. This is an important point to consider when making investment decisions because the overall results presented in Table 2 hide this tendency. We understand that there is an obvious survivorship bias in these results. Because our study period encompasses 25 years, there will be a number of mutual funds that perform poorly and disappear from our sample in the later years. As such, this bias favors active fund management over indexing and any indexing (active) advantage would be greater (less) than reported. Conclusion This paper’s primary contribution is in providing more conclusive evidence on the debate on the benefits of mutual fund indexing and whether actively managed funds perform as well as index funds. An important feature of this research is that we analyze the results for both total return and after-tax total return. We find that, on average, index funds outperform actively managed funds for most equity and all bond fund categories on both a before-tax and after- tax basis. However, actively managed Small Company Equity (SCE) funds and International Stock (IS) funds significantly outperform the index over most of the study period. Managers of these funds appear to be able to invest to take advantage of mispricing in these presumably less efficient markets. The nonparametric tests further reinforce these results. The Sign Test establishes that index funds outperform actively managed funds for all categories, except SCE and IS funds. The overall results should be viewed with caution, however, as there is evidence that actively managed funds outperform the index funds during periods when the economy is either going into or out of a recession. It appears that active fund management is better than index funds at guiding portfolios through rough times. A number of caveats are also in order. First, this study does not consider either front or deferred loads, and the relative performance of index mutual funds versus actively managed load or no-load funds is an empirical question left unanswered by our study. Second, the methodology in this study does not take into account a risk/return trade-off. We only examined returns by category, and a number of funds with lower returns might actually have a better risk/return trade-off than the market because they have lower risk than the market. Third, our tests do not take into account persistence of fund superiority over the passive index fund. Any fund that consistently outperforms the market index tends to be averaged out in our cross-sectional methodology. There is a large body of literature in this area [see Zheng (1999)] and this study does not explicitly address this issue. Endnotes 1. Note that the total number of mutual funds represents totals over different time periods. For example, AGG funds were examined over 1977 through 2000 and IS were reviewed over the years 1997 through 2000. 2. The index funds represent specific segments of the market. The Vanguard Index 500 fund reflects the S&P 500 Index, the Vanguard Total Bond fund reflects the Lehman Brothers Aggregate Bond Index, the Vanguard Small Cap fund reflects the Russell 2000 Index, the Vanguard Total International fund reflects the MSCI European, Pacific and Emerging Markets Indices and the Vanguard Balanced fund reflects the combination of the Wilshire 5000 and the Lehman Brothers Aggregate Bond Index. 3. More specifically, the ending net-asset value from the prior year is multiplied by one plus the decimal return for the current year. Then the computed tax on the ordinary income and capital-gain distributions for the year are subtracted from this appreciated net-asset value to give an after-tax net-asset value. After-tax total returns are then computed by dividing the after-tax net-asset value by the ending net-asset value from the prior year and subtracting one. References Arnott, R., A. Berkin and J. Ye. "How Well Have Investors Been Served in the 1980s and 1990s?" The Journal of Portfolio Management. 26, 4 (Summer 2000): 84–91. 2002_Issues/jfp0902 (10 of 11)
  • 11. FPA Journal - Indexing Versus Active Mutual Fund Management Bogle, J. "The Triumph of Indexing." The Vanguard Group (April 1995): 1–45. Bogle, J. "Be Not the First…Nor Yet the Last." The Vanguard Group, from a speech presented May 8, 1996, at the 1996 AIMR Annual Conference in Atlanta, Georgia. Bogle, J. "What Can Active Managers Learn from Index Funds?" The Vanguard Group, from a speech present to the Bullseye 2000 Conference in Toronto, Canada, December. Elton, E.J., M.J. Gruber and C.R. Blake. "The Persistence of Risk-Adjusted Mutual Fund Performance." Journal of Business. 69, 2 (1996: 133–157. Fortin, R. and S. Michelson. "Mutual Fund Indexing Versus Active Management." Journal of Financial Planning. 12, 2 (1999): 74–81. Gruber, M.J. "Another Puzzle: The Growth in Actively Managed Mutual Funds." The Journal of Finance. 51, 3 (July 1996): 783–810. Lowenstein, R. "Indexing’s Real Uncertainty Principle." The Wall Street Journal (January 30, 1997): C1. Malkiel, B. "Not So Random." Barron’s (April 22, 1996): 55. Malkiel, B. "Returns from Investing in Equity Mutual Funds 1971 to 1991." The Journal of Finance. 50, 2 (June 1995): 549–572. Morningstar Mutual Funds. Mutual Funds OnDisk, operations manual, Chicago, Illinois: January 1996. Siegel, B. and D. Montgomery. "Stocks Bonds and Bills after Taxes and Inflation." Journal of Portfolio Management (Winter 1995): 17–25. Wermers, R. "Mutual Fund Performance: An Empirical Decomposition into Stock Picking Talent, Style, Transactions Cost and Expenses." The Journal of Finance. 55, 4 (August 2000): 1,655–1,703. Zheng, L. "Is Money Smart? A Study of Mutual Fund Investor’s Fund Selection Ability." The Journal of Finance. 54, 3 (June 1999): 901–933. 2002_Issues/jfp0902 (11 of 11)

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