Top of the Class

Charles D. Ellis

AMONG PENSION PLANS, foundations and other institutional investors, the dream is to invest with top-quartile money managers. But, alas, that appears to be an impossible dream. Most managers end up disappointing.

Sadly, it’s the same for everyday investors who buy actively managed funds. Most funds wind up lagging behind the market averages, and that’s before factoring in the high taxes these funds often generate and the extra risks they take.

Lots of reasons for this failure have been identified: Money managers stray from their investment discipline, their assets under management grow too fast, they lose talented employees, the firm gets acquired, and so on. Is there any way to avoid these problems and achieve success? Yes, there is. Even better than that, it’s duck soup easy.

S&P Global’s rigorous analysis of mutual-fund results over the long term—meaning 10 or 15 years—documents that there’s an easy way to ensure top-quartile performance. The same easy way works well for growth or value, for large cap or small, and works in every developed stock market.

The easy way to achieve top-quartile results—and even get into the top half of the top quartile—is to invest in a low-cost index fund that replicates the market and stays the course. Yes, it’s that simple and that easy.

But why is this so? There are two reasons.

First, the stock market has been transformed over the past half-century, as professional investors have gone from 9% of trading volume to 90%. Second, the markets’ price-discovery mission is being wonderfully fulfilled thanks to fabulous computers, Bloomberg terminals, instantaneous access to all sorts of information from all over the world 24/7, and increasing regulation to ensure equal access to all this information. The result: Not only do market-dominating professionals spend their days buying from and selling to other equally hard-working and capable professionals, but also almost all of these folks almost always know almost everything almost always at the same time.

Not surprisingly, it’s really hard for the experts to regularly outperform the other experts, particularly once we factor in their management fees and the other costs involved. This is where index funds get their edge. Since index funds have little turnover, their operating costs are very low. Since they do very little trading, the tax bills they generate are also very low. And, most important, their fees are very, very low, particularly in comparison with actively managed funds, so they end up capturing more of whatever the market delivers.

Another big benefit of indexing: Since investors don’t need to “sweat the details,” they’re free to focus on the truly important aspects of investing. What are my long-term goals? When will I be spending the money now being invested? What asset mix will get me there with the most confidence along the way, so I can stay on plan with confidence?

All of which explains why there’s an easy answer to the hard question. Can we identify top-quartile managers ahead of time? Yes, we can—if we’re willing to look in the right place.

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