Index Funds: Price vs Value

I had a meeting with a client last week and we had a debate over the use of “managed” vs “index” mutual funds. Managed funds are those that have a team of stock analysts led by a manager or team of managers. Index funds are passively “managed” mutual funds that seek to mirror an index or “benchmark”.  There are many, many indexes in the investment universe. Perhaps the best known two are the S&P 500 and the Dow Jones Industrial Average (“DOW”, “DJIA”, “DOW 30″). The S&P 500 (Standard and Poor’s 500) index is 500 US publicly traded stocks that strives to represent the entire U.S. stock market. The DOW is 30 stocks that seeks to represent the best examples of corporations of 30 diverse industries in the U.S. The DOW “average” is the average of the sum of a single share of each of those companies. I have been following the DOW since I was licensed to sell securities in 1993 and that is the index I use to watch the “Market”.

My client has heard a great deal about how index funds are so much cheaper than managed funds. She was led to conclude that since they are cheaper they must have higher rates of return. After all, common sense dictates that if something costs less to operate then it can deliver more value than something that costs more to operate. I did not have the facts at my fingertips so I had to assert my philosophy instead. The advisors’ “rule of thumb” on the topic is that about 20% of mutual funds beat their index. That does not mean that the same funds or same fund management teams are consistently in this quintile. I also hold that active fund management presents the possibility that short term events, whether  natural, political, industry-wide, sector-wide, or even news about a particular stock can be taken advantage of or “leveraged”.

This morning I set out to test my theory using a real mutual fund in my portfolio. I found a corresponding index fund and learned that the index fund had a total expense ratio (“expense”) of just .20% while the fund in my portfolios was 1.06%; more than 5 TIMES HIGHER! You would think then that the index fund was delivering a higher “net” (after fees are deducted) rate of return because it didn’t have “all those fees”. I was pleasantly surprised, however to see that my fund had more than 47% higher net rate of return (NROR) for one year; about 800% higher NROR for the 5 year average and more than 35% higher NROR for the 10 year average. Morningstar reports that in the past year there were 773 mutual funds in this category. My fund, rated “5 Stars” was #1 while the index fund was #17 (3 Stars), still very good.

How can this happen? There are several factors. First I noted that the index fund had 906 stocks in it while the managed fund had only 56. The index fund might hold all the stocks the index holds in an effort to “mirror” the index. Since the managed fund has no such obligation, it can hold a much smaller number of stocks making it easier to not only track their performance but to actually track their governance, inventory, research and development, product liability risk, labor stability and a host of other issues. This information can be used to accurately predict the profitability of a company and possibly, a corresponding future demand for its stock.

The managed fund can take advantage of the fluctuations in events to buy and sell not just 56 stocks but any in the universe of that category. The managed fund had a turnover of 38% compared to just 8% for the index fund. Turnover is the proportion of stocks traded in the fund over a given period of time. This leads one to believe that the managers are trading the stocks in the portfolio and generating capital gains. Capital gains are part of a fund’s “total return”; a performance factor missing from the not actively managed index fund.

Indeed, the Morningstar report shows a potential capital gains exposure of 15.96% for the managed fund while the index fund has just a 1.25% potential for capital gains. This is a tax liability issue for the investor and many shy away from this. The maximum capital gains tax rate is 15% and I will argue that 85% of something is a whole lot better than 100% of nothing. I think that the additional expense of .86% for the managed fund is money well spent because it delivers a whole lot of value for that expense.

I could buy a pair of lace up oxford dress shoes at Payless Shoe Source for $25 and they might even be leather. However, I choose to buy a pair of $120 Bostonian lace up oxford dress shoes instead. Why? They don’t pinch, take a shine and fit from day one. I don’t have any Payless shoes I bought in 1980 in my closet but I have several pairs of Bostonians from 1980. This is the difference between “price” and “value”. The same holds true for mutual funds. Maybe not always but a whole lot of the time.