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Originally posted by Hank Chinaski
Burton Malkiel, author of A Random Walk Down Wall Street and Professsor at the University of Chicago, as well as many other pundits of managed funds have consistently studied and verified that the average MANAGED mutual fund does NOT outproduce the S&P 500 index. William Sharpe, who won a Nobel prize in economics for his studies on securities, noted that on a net of expense basis, in the aggregate, fund and institutional managers will tend to underperform the market by an amount equal to the fees that they charge for managing the portfolio, plus associated costs. Vanguard's Bogle's study of the Wilshire 5000 Index from 1971 to 1990 tended to show exactly that- professional managers underperformed the index by an average of 1.8% per year- approximately the cost of managing the fund; 1% for management fee, 0.5% in fund transaction costs and 0.3% due to cash positions required by investor inflows and outflows. Another study by Brinson, Hood and Beebower of the quarterly returns of 91 large pension funds between 1974 to 1983 compared the returns from the asset classes they were investing in. 93.6% of the return was explained by the movements in the underlying asset classes they were investing in. They also showed that active managers, in the aggregate, underperformed the benchmarks by 1.10% a year. In other words, the active selection of stock did little to nothing to the overall return- it was where the money was invested that made the difference. Money Magazine (August, 1995), though certainly not an education tool in itself, also had a lengthy commentary regarding how passive investments (index funds) should be considered because of the lack of management expertise in consistently beating or even meeting the S&P 500 Index annual returns. A study by Barksdale and Green of 144 institutional equity portfolios over the rolling 10 year periods between January 1, 1975 and December 31, 1989 showed that portfolios that finished the first five years in the top quintile were actually the least likely to finish in the top half over the next five years. The results were entirely random. That meant that what might have beaten the market for a certain period of time had little consistency in doing so in the near future. Robert Stalla, instructor for Chartered Financial Analysts, stated in his material that "a properly diversified portfolio should be utilized first in many portfolios unless there is a compelling reason to do otherwise". Most recently, Jack Beebe, Director of Research for the Federal Reserve Board of San Francisco and a former stock and bond analyst, stated that "I learned that you cannot easily beat the market" and uses mostly index funds in his portfolio. The point with this limited commentary is that 401(k) funds, since they are limited in number, should at least offer a S&P 500 index fund as well as an Intermediate Bond index fund since these could/should be the major platforms from which an investor then moves. That is not to say that an investor MUST use them, but that they are made available. Without adhering to basic investment teachings, XXXXX Training Corporation is probably at risk in the future if the funds actually selected underperform baseline indexes- particularly when high fees are also noted.


Admittedly, this review is not to suggest that managed funds cannot or do not provide returns exceeding the S&P 500 index. A study by Lipper found that, in the extreme, with the very good and the very bad funds, there does tend to be repetitive performance under similar conditions. Therefore, from the vast universe of funds, it is possible to use a fund(s) that can consistently outproduce the market- at least for some period of time. But another study reviewed the Forbes Honor Roll over periods of 1980- 1984 and 1986- 1990. Only once did those in the honor roll outperform, in the aggregate, the S&P 500 index- and that by a very slight margin in the first five year period. Further, the group never outperformed both the index and the average equity fund during any five year periods. So, since a 401(k) plan offers normally just a few funds from one fund family, the odds of one of those funds consistently outproducing an index, on a risk adjusted basis, is relatively remote. It again reinforces the necessity of the offering of some index funds.


The above is corroborated by the returns of the funds selected. The Basic Value (mostly growth but with some income) has generally underperformed the market. The Capital Growth (mostly growth but with convertible securities and cash) and the Global Allocation Fund (both US and Foreign securities) have both consistently underperformed the index for all periods. That does not mean that an investor may not wish to use them nor that they might outperform an index. But when employees have NO CHOICE but to pick a fund(s) that has consistently underperformed the market, I believe the company is at risk for future liability in not recognizing basic investment teachings and reflecting that in the offerings.


While the B category funds (all the above) are exempt from the back end loads under a retirement plan agreement with Merrill Lynch, they still are subject to a 1.00% 12b-1 fee for eight years on the Global Allocation, Basic Value and Capital Fund, a .75% 12b-1 fee for ten years on the High Income and Investment Grade portfolios and a .50% 12b-1 fee for ten years on the Intermediate Bond portfolio. Even though most of the 12b-1 fees are reduced to "just" .25% at those times, the cumulative 12b-1 fees are comparable to a 6.25% (6.75% at the discretion of Merrill Lynch) total load. Additionally, high 12b-1 fees on bond funds simply reduce return overall since appreciation is not a usual consideration for bond funds today.


All the funds must attempt to outperform an index just to account for these fees- and have essentially been unable to do so. As regards bond funds, it is generally held that bond investment and returns are effectively limited for all portfolios of similar ilk and that the only way one fund can outproduce another is to take more risk- either through lower rated bonds or by use of derivatives. The returns on the Intermediate and Corporate bond portfolio have clearly underperformed the indexes. The High Income portfolio, as compared to Vanguard's High Income portfolio, shows a lower return for almost all periods and with higher risk. While I am certainly not advocating Vanguard as your fund choice, it would be utilized as a gauge in almost all law suits regarding the suitability of fund selection.


In conjunction with the above, it is necessary to relate how the overall fees compare to industry standards. I have included several performance reports for Vanguard since they are the industry gauge for low costs. The difference in fees is most notable on bond funds. Merrill's High Income management fee is 1.29%- Vanguard is .35%. Merrill's Intermediate portfolio fee is 1.04% while Vanguard charges .18%. There are other issues that could substantiate the higher fees- service is one- but they still must be viewed in terms of performance.

I'm just sayin....

If you don't have anything managed, you can't have an index, though.