Why should I invest in Index Funds?

This weekend, hopefully, our Finance professor will tell us what's wrong with investing in Mutual Funds and why we should invest in Index Funds.  Why would we settle for market returns if we can safely beat the market?

Above, from Morningstar, you can see the first 50 actively managed mutual funds that have beat the S&P 500 over the last 15 years, as well as the last 10 years, as well as the last 5 years, and 3 years, and 12 months, and even over the past 3 months, and that also have a Beta <= 1!  This is a very tough requirement, but as you can see, there are 219 funds that have done that well.

Comments

[Shane Underwood]

First, you put together a good argument. You've identified funds that beat
the market over a long time period, and you have been careful to adjust for
the risk they have taken on by only looking at funds with a beta < 1. But
problem #1 is that you probably haven't fully adjusted for risk. First,
using a 3-year beta to risk adjust for performance over a 15-year period is
probably not a good idea, but let's let that slide...

What's bigger is that you need to consider additional risk factors.
Standard practice in the industry is to risk-adjust using a three (or
usually four) factor model. So you really need to adjust for beta, SMB,
HML, and momentum factors. The universe of funds that outperform (ie,
generate positive "alpha") after adjusting for those factors will be much
smaller.

Another concern...how are fees factoring into these returns? They may be
included, but I can't remember how Morningstar treats them. An actively
managed mutual fund needs to not just outperform on a risk-adjusted basis,
but needs to outperform by enough to cover the extra fees that I have to
pay.

Having said all this, I *know* that some funds will beat the market on a
risk-adjusted basis over the next 10 or 15 years. So why do I still invest
in index funds? Because I don't know *which* actively managed funds will
outperform. One could argue that I should pick funds that have outperformed
in the past...but the evidence for persistence in fund abnormal performance
is pretty weak. So while it may be a boring approach that will cause me to
miss out on some big outperformance in any given year from a hot fund, I
know that over the long haul it will probably be the best approach for me to
maximize returns. I say probably because there is some chance that I could
pick the right actively managed fund that will outperform net of fees. But
the odds are pretty small.

I hope this helps clarify things. I have nothing against active management
in general...in fact, as I said in class, it is the very existence of active
managers searching for inefficiencies that keeps the market fairly
efficient. The problem is just that the empirical evidence isn't very
friendly to active managers once we take into account the fees they charge.

[Philip Bryant]

Well, there you have it folks.
The smart money is in index funds. I guess I still don't want to believe that it's all that hard to find good funds to invest in.