The debate is over: Index funds beat active investment management, hands down, Michael Hiltzik says. The least surprising financial news nugget in recent days may have been this one from a Bloomberg interview with Peter Lynch , one of the most venerated stock market gurus of our time.
Lynch, 77, told Bloomberg that the wholesale move of investors in recent decades from actively managed mutual funds to passive investing — that is, index funds — is “a mistake.”
He said, “Our active guys have beat the market for 10, 20, 30 years, and I think they’ll keep on doing it.” The index fund was at first ridiculed, then tolerated, then grudgingly accepted, then reluctantly endorsed, and finally copied en masse. On Wall Street, this is known as talking one’s book. Lynch, of course, was the quintessential active investment manager, renowned for his stock-picking skills. Fidelity Magellan Fund, the mutual fund he ran from 1977 to 1990, was the quintessential actively managed mutual fund.
By giving Magellan investors an annualized return of more than 29% — compared with an annualized gain in the Standard & Poor’s 500 index of about 15% during the same period — Lynch grew Magellan’s assets under management from $18 million to $14 billion, making it the largest mutual fund in the world.
Magellan lost that crown in 2000 to Vanguard’s S&P Index Fund, the quintessential passively managed mutual fund.
Lynch’s remarks play into the enduring debate about which is better for investors, active management or passive, and under what circumstances.
If his remarks are taken as advice at face value, then they’re a disservice to the average retail investor.
That’s because the debate has long since been resolved by reality: Active investment managers consistently fail to match or exceed the benchmark indices of their funds. Passively managed index funds, by definition, always hit their benchmarks.
More than 57% of all U.S. domestic stock funds underperformed their benchmarks in 2020, according to the latest S&P Indices Versus Active scorecard , known as SPIVA.
In some categories, the record was even worse: About 60% of all large-capitalization mutual funds failed to match the S&P 500 index, and more than 80% of midsized core mutual funds fell short of the S&P MidCap 400 index.
The record isn’t any less dismal over longer periods. More than 67% of actively managed U.S. equity funds underperformed the S&P Composite 1500 index, which comprises 90% of all U.S. publicly traded companies, over three years; 72.8% of funds fell short over five years, 83.2% fell short over 10 years and 86% over 20 years.
It’s proper to note that Lynch probably didn’t set out to offer investment advice. His remarks to Bloomberg came chiefly in connection with the announcement of a donation of $20 million in artworks to his alma mater, Boston University. Pressed to comment further on the record of active vs. passive management, he said, “I don’t keep score. I’ve got 10 grandchildren. … That’s what I keep score on.”
But he also pointed to the performance of three Fidelity fund managers to validate his general claim that active beats passive.
It’s true that his three exemplars have done well, but many of Fidelity’s actively managed funds have not met their benchmarks. That includes Magellan, on an after-tax basis — an annualized gain of 15.3% over 10 years, after taxes on distributions, versus the S&P 500’s average gain of 16.63% per year.
So it’s proper to take a closer look at Lynch’s viewpoint and its context.
First, some fundamentals. Traditionally, stock mutual funds were operated by investment managers who aimed to find the best values in the equity markets, traded actively to capture gains and dump their dogs, and collected healthy fees for their efforts.
That model was upended in 1976 by John C. Bogle, who introduced the first index fund at Vanguard, which he founded. Bogle felt that the best way to serve small investors was to offer them low-cost funds tied to broad market indices.
Because they had to match the indices’ baskets, which seldom change, they would do relatively little trading and thus would incur few tax liabilities, which only get passed on to investors. They required “no management whatsoever,” at least in terms of stock-picking, Bogle recounted years later .
That first fund, keyed to the S&P 500 index, was denigrated as “Bogle’s Folly.” As he recollected, “the index fund was at first ridiculed, then tolerated, then grudgingly accepted, then reluctantly endorsed, and finally copied en masse . It has changed how we think about investing.”Today there’s scarcely a mutual fund firm that doesn’t include […]
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