Sunday, July 02, 2006

The Case for Index Funds

Today's NY Times reports more evidence for the efficient-markets hypothesis:

ASSUMING that the future is like the past, you can outperform more than 80 percent of your fellow investors over the next several decades by investing in an index fund — and doing nothing else.

That's the clear implication of a continuing study of investment newsletter performance conducted for the last 26 years by The Hulbert Financial Digest. Returns of model portfolios constructed according to investment newsletters' advice show that fewer than one in seven newsletters was able to beat the Standard & Poor's 500-stock index over the long term....

The results for newsletters are close to those for mutual funds. According to Lipper, the fund-tracking company, just 19 percent of United States mutual funds that have existed since mid-1980 were able to beat the S&P 500 through May of this year. The average return of all such funds was 10.9 percent, annualized, compared with 10.4 percent for the average newsletter portfolio and 13.0 percent for the S&P 500.

These comparisons ignore taxes. On an after-tax basis, the superior performance of index funds would be even greater, because index funds are particularly good at deferring realization of capital gains.

According to Morningstar, over the past 10 years, Vanguard's S&P 500 Fund beat 74 percent of comparable funds on a before-tax basis and 86 percent on an after-tax basis. Even better is Vanguard's Tax-Managed Capital Appreciation Fund, which is essentially an index fund that keeps one eye on the tax system. It beat 90 percent of comparable funds on an after-tax basis.