Why Indexing Is So Hard to Beat

In investing, everyone wants to outperform the market. But unlike the children of Lake Wobegon, who can all be above average, the vast majority of professional money managers who seek to beat the market average end up failing miserably.

The latest numbers from S&P Dow Jones Indices put the massive failure of Wall Street managers into perspective. Let's take a look at those numbers first, and then ask the natural follow-up question: Why is it so hard to be above average?

Falling short
For all that money managers get paid, they routinely fall short of the performance you could get from a simple index fund. Over the past five years, nearly two-thirds of managers of large-cap stock mutual funds have fallen short of the returns of the S&P 500. That's a black eye for the pros seeking to justify their paychecks in their bout with extremely cheap index-fund alternatives.

Some might argue, though, that it's hard to get an edge with large-cap companies. After all, dozens of analysts routinely scour the financials of most of the biggest companies in the U.S., and it's unlikely that any one manager will have insight that somehow escapes others.

Conversely, small- and mid-cap stocks tend not to be followed as much by Wall Street analysts. You might therefore conclude that active fund managers should be better able to capitalize on undiscovered opportunities in the small- and mid-cap space.

Yet the numbers are even more dire for smaller stocks. More than 80% of actively managed mid-cap stock funds trailed the popular S&P MidCap 400 index, while the S&P SmallCap 600 index did better than 78% of all active small-cap funds. Just about the only good news came from the international stock realm, where three-quarters of international small-cap managers beat their benchmark.

It's even worse
As bad as those numbers are, what's even worse is how many investors fall short of even the average returns their funds produce. That's because typically, fund investors jump in after a fund has generated strong performance, and then get out at the worst possible time -- after a down period for the fund.

Perhaps the most obvious recent example is the Fairholme Fund, managed by Bruce Berkowitz. In 2011, Fairholme performed abominably, with a 32% loss landing the fund at the very bottom of the pack. Big bets on financial stocks proved to be bad calls and cost the fund terribly, and shareholders exited the fund in droves.

Yet those who stuck around got at least some vindication this year, as the fund has soared more than 30% year to date. The reason? Berkowitz's most aggressive bets have panned out a lot better in 2012. AIG (NYSE: AIG  ) has come a long way toward selling off noncore businesses and getting the federal government's stake in the company down to a manageable level, and despite big share sales from the Treasury, the stock has jumped more than 40% so far this year. Even better news has come from Sears Holdings (Nasdaq: SHLD  ) , as CEO Eddie Lampert has started taking steps to unlock the value of the company's assets despite continuing lackluster performance from the retail business. Bank of America (NYSE: BAC  ) has also shaped up considerably, gaining credibility from Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) investment in the banking giant and positioning itself for the new reality under a more highly regulated industry.

It takes discipline to stay the course during bad times. Yet by bailing out at the worst moment, you compound the disadvantages that even well-managed funds have to overcome.

Keep it easy instead
If you don't have that discipline, it's easier just to stick with an index fund and ride the ups and downs of the overall market. With actively managed funds having extra fees to pay, it's not surprising that most of them fail to match the returns of their index counterparts. As humbling as it may be to accept being average, using index funds for your core portfolio can still leave you far better off than trying to buck the odds and beat the market.

Making some individual stock plays, however, is a good way to use your knowledge. Being smart about it requires information. For instance, Bank of America has come a long way, but is it really everything it once was? Find out about its prospects in the Fool's premium report on Bank of America, which you can get easily just by clicking here.

Fool contributor Dan Caplinger can't help but try to beat the averages. You can follow him on Twitter @DanCaplinger. He owns shares of Berkshire Hathaway and Fairholme Fund. The Motley Fool owns shares of Berkshire Hathaway, Bank of America, and American International Group. Motley Fool newsletter services have recommended buying shares of American International Group and Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is hard to beat.


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