Passively managed index funds overtook actively managed funds in late-2019 as low-cost exchange-traded funds (ETFs) replaced higher-cost actively managed mutual funds. Financial advisors and other financial experts have embraced these funds as a way to build portfolios that outperform hedge funds and other active approaches to investing in the markets.
Let’s take a look at the pros and cons of market capitalization weighting mechanisms and some alternatives to consider for your portfolio.
Be sure to check our Portfolio Management to learn more about different ways to structure or rebalance your portfolios.
Passive Indexes Outperform
Stock market indexes, like the S&P 500 index, are typically weighted by market capitalization. The largest companies have a greater effect on how the index performs than smaller companies. For instance, the top five companies in the S&P 500 index represent over 20% of the overall index while the bottom five stocks make up less than 0.05% of the total.
Warren Buffett and other investment icons have been long-time advocates for low-cost passively managed index funds. In fact, the Oracle of Omaha bet hedge fund manager Ted Seides $1 million that he couldn’t outperform the S&P 500 index over a ten-year period. Buffett officially won the bet at the end of 2017 with a score of 62.8% to 22%.
According to Dalbar Associates, the average equity fund investor underperformed passively managed index funds by 2% annually in the 20 years ended December 31, 2019. The S&P similarly found that 89% of domestic equity funds and 65% of institutional separate accounts underperformed their benchmarks, net of fees, in the 10 years ended December 31, 2019.
The Irrationality of Indexes
Few managers may be able to beat passive index performance, but that doesn’t make indexes a panacea. According to a Cass Business School study, portfolios with non-market capitalization-based weightings outperformed market capitalization-weighted portfolios between 1969 and 2011—including portfolios that were randomly weighted!
NBER researchers believe that flows into index funds disproportionately raise the price of large stocks. Noise traders focused on momentum and other non-fundamental strategies distort prices and bias index weightings. When market capitalization-based funds experience inflows, they primarily buy these stocks, causing them to become overvalued.
The reason that active managers fail to outperform is a combination of high fees and trouble sticking to the strategy throughout underperforming years. In the Cass Business School study, there were numerous periods in which randomly generated portfolios underperformed the market. In practice, investors aren’t patient enough with fund managers.
Alternatives to Consider
Smart beta funds have attempted to address these issues by taking a hybrid approach. Unlike expensive actively managed funds, smart beta funds take a methodical index-based approach to building a portfolio that differs from market capitalization weighting mechanisms—potentially offering market-beating returns.
In the NBER report, researchers noted that flows into index funds predict a high future return for small-minus-large index portfolios. They found that such portfolios earned ten percent per year between 2000 and 2019, significantly outperforming large-cap stocks in the index, and surprisingly, small cap stocks that were not in the index.
Investors may want to consider low-cost smart beta funds focused on smaller companies with attractive fundamentals. While these funds may underperform indexes at times, research suggests that they will outperform passive index funds over the long run if investors can withstand the potentially greater risk and volatility in the interim.
There are also a handful of actively managed mutual funds that have been strong performers over the long run:
- Vanguard Wellington Fund Investor Shares (VWELX)
- Fidelity Magellan (FMAGX)
- T. Rowe Price New Horizons Fund (PRNHX)
Don’t forget to check out this article to know how smart beta strategies can be helpful.
The Bottom Line
Index funds tend to outperform active managers over the long run. Despite the outperformance, research also shows that non-market capitalization-based weighting mechanisms tend to outperform standard indexes. Smart beta funds and other strategies aim to capitalize on these dynamics to help investors produce outsized returns.
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