How the S&P 500 Index Beats Mutual Funds

“[The S&P 500 index] is the most historically reliable single metric of the US market over the past 140 years for both price and dividends. The early Dow 12 was too small and volatile to be a proxy for the broader US market, and the Dow of the past few decades also lacks sufficient diversification to be the best single gauge of the US equities market.” – Doug Short

 
According to the New York Times of the 2862 US stock mutual funds that existed in March 2009, not a single one has beat the market. How Many Mutual Funds Routinely Rout the Market? The answer is zero. When you buy a managed mutual fund the odds are that the manager will not be with the next Peter Lynch but instead you will get someone who charges you a management fee for underperforming their benchmark. Their fees will also eat into your capital over the long run. Loses 1% to 2% of your capital to fees each year hurts your moneys ability to compound and grow. It is like a leak in your financial boat. Mutual fund managers have a very good business model at least from their perspective. The investor (That would be you) takes all the risk and they get paid set fees regardless of their performance. Mutual fund managers collect big fees for the expectation of doing one thing: beating their benchmark. Manager of mutual funds that invest in big cap stocks should beat the S&P 500 while small cap mutual funds should beat the Russell 2000. That is their job. If they can’t do that what is their purpose for existing? Over the long term 80% of mutual funds do not beat their benchmarks. What that means is that the SPY ETF beats 80% of active managed mutual funds.
 

The SPY ETF beats 80% of mutual fund managers for three primary reasons:

 
It has a very small management fee of .09%.
It follows the S&P 500 index rule based system.
It is managed in a mechanical way not based on a manager’s opinion of emotions.
This is an edge.
It can’t underperform the market because it is the market.
Mutual funds also have a built in disadvantage to their benchmark due to expenses for management, administrative fees, and brokerage expenses, these expenses can range from 0.2% for an index mutual fund up to 2% for some managed funds. The 80% of mutual fund managers that do not beat the S&P 500 still get paid which reduces their overall returns. The mutual fund manager gets paid before the investors and receives a paycheck whether they create a return or not.  If they are managing a $100 million mutual fund they could be making $1 million a year if their pay is just 1% of the fund. If their administrative fee is 2% of assets under management then they would really have to beat the S&P 500 by 2% just to be even. One of the main reasons that so many mutual fund managers can’t beat their index is that they have to beat the index by the amount of their administrative fees so they start in the hole.

The biggest reason that mutual fund managers have difficulty beating their benchmark index is that an index is a mechanical system. The S&P 500 is weighted by market cap and stocks enter and leave their index based on their size. So companies that do well and grow in market capitalization enter the S&P 500 and the companies that drop in size fall out of the index. The biggest most successful companies in the world that are in a price uptrend get the most weighting in the S&P 500 while the weighting drops for the less successful companies that have prices in downtrends. The S&P 500 index system is designed to let winners run and drop losers out of its holdings. This is a trend following system due to the way it is built. The S&P 500 index also has a survivor bias built in. The companies that are going bankrupt leave the index early as their price drops out of the market cap threshold and the new growing companies enter the index early when they grow to a certain market cap size. The S&P 500 is not stagnant it is letting its winners run and cutting its losers short. The S&P 500 index is managed as a rule based system and is another edge it has over mutual fund managers that could make emotional, opinionated, and ego driven decisions at times leading to making bad choices and timing in their holdings. The committee that select the components are largely free from the pressure of quarterly returns and performance pressures so can choose the S&P 500 components in a more academic rule based way than mutual fund managers can choose their funds holdings. This is an edge as it removes the filters of emotions, ego, and stress that lead to so many mistakes in the investing world.

Indexes are adaptive and designed to reflect the American economy. They are also diversified across different sectors.

“When considering the eligibility of a new addition to the S&P 500 index, the committee assesses the company’s merit using eight primary criteria: market capitalization, liquidity, domicile, public float, sector classification, financial viability, length of time publicly traded and listing exchange.”

“The committee selects the companies in the S&P 500 so they are representative of the industries in the United States economy. In order to be added to the index, a company must satisfy these liquidity-based size requirements.”

• Market capitalization is greater than or equal to US$5.3 billion

• Annual dollar value traded to float-adjusted market capitalization is greater than 1.0
• Minimum monthly trading volume of 250,000 shares in each of the six months leading up to the evaluation date.

– Wikipedia

Indexes are dynamic and evolve with the economy and advancing technology. They do not rely on the skill of a money manager they follow the biggest trends of the times. Let’s take a look at the long term evolution of an index. Since the S&P 500 has so many components let’s look at the more manageable in size Dow Jones Industrial Index.

Here are the original 12 Dow Jones Industrial Components of 1896:

• • American Cotton Oil
  • American Sugar
  • American Tobacco
  • Chicago Gas
  • Distilling & Cattle Feeding
  • General Electric
  • Laclede Gas
  • National Lead
  • North American
  • Tennessee Coal Iron and RR
  • U.S. Leather

• United States Rubber

At the turn of the 20^th century the United States was a primarily agrarian economy as is reflected in the index. Electricity was just at the beginning of its growth stage. Commodities were growing industries to keep up with the industrial revolution and the growing American economy. This index reflected the times and would have had investors in some of the healthiest companies of that time.

But things change, that is why indexes change.

Here is a list of the current 30 Dow Jones Industrial Average Components in 2016:

Dow Jones had to over double its components to get a better representation of the American economy. The S&P 500 has enough stocks so it has plenty of components to get investors a piece of all sectors and industries.

In this index we see the 20^th century technologies and industries represented. Credit cards, airplanes, industrial equipment, computers and computer chips and systems, software, chemical productions, entertainment, retail, financial services, medical, fast food, apparel, we are still using oil, and even General Electric from 1896. The DJIA evolved with the times in real time. Companies left as they were no longer leaders in the economy and new leaders emerged to enter the Average. An index will do the work for passive investors. Indexes are systematic and rule based in their selection of components. They pick the strongest leading stocks, they diversify across all industries, they let winners run and cut losers short, their holdings are liquid, you can get exposure without all the transaction costs if you tried to build the index yourself by buying all 500 stocks in the S&P 500.

The most simply way to buy into an index is to purchase an index tracking ETF:

SPY is the ticker for the S&P 500 exchange traded fund.

DIA is the ticker for the DJIA exchange traded fund.

QQQ is the ticker for the NASDAQ 100 exchange traded fund.

IWM is the ticker for the Russell 2000 exchange traded fund.

These ETFs can be bought and sold just like stocks intra-day and even in the afterhour’s market. They provide liquidity and easy entries and exits with your investments. These are available in most Individual retirement accounts. 401Ks will likely only offer index mutual funds. These are also great choices that provide the same benefits as index ETFs. Mutual funds only give quotes at the end of the day and only trade at the end of the day so there is a disadvantage. However investors should be using entries and exits at the end of the day so this should work with little issues. Look for the word ‘index’ in your mutual fund options inside your 401K and look into the prospectus to see which index the mutual fund tracks along with the management and expense of the fund.

Mutual fund products to avoid:

Never purchase a mutual fund with a load charge. There are front-end load mutual funds and back-end load mutual funds. This means if the mutual fund pays the broker that sold you the fund a 5% commission then if you put $10,000 into the fund on a front-load fund $500 goes to the broker and $9,500 goes into the fund and you start with a 5% loss. If it is a back-end load fund you pay the load fee when you withdraw the funds. Also be aware of any redemption fees that you will be charged when you withdraw your funds. In the age of no-load mutual funds, ETFs, IRAs and 401Ks there is no reason to ever buy a mutual fund that charges you for your purchase. Find low management fee no-load mutual funds.

This is Chapter 7 from my book Investing Habits.