Money Tip
Index Funds: Risk-adjusted Winners

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By Robert Brokamp (TMF Bro)
August 21, 2002

You've probably heard the argument for index funds: Mutual funds that attempt to match the performance of a broad-market index (such as the Standard and Poor's 500) outperform most actively managed mutual funds over the long term. When financial advisors are confronted with this line of thinking (which they rightly interpret as "Why should I pay you when I can just buy an index fund?"), they often bring up the topic of risk. In fact, some will say they can beat the market... and take on less risk in the process.

It's a common claim, and Scott Burns decided to challenge it. Burns -- a journalist for The Dallas Morning News who famously took on Peter Lynch's all-stock strategy (which Lynch said could survive a 7% withdrawal rate) -- fired up his Morningstar database of mutual fund stats. His goal: to prove that "building a portfolio where you'll get more return and less risk than a portfolio built with index funds is very difficult." Here are the results of three surveys he performed of the Morningstar universe:

  • Burns started with all domestic equity funds that have been around for at least five years. Of those funds that met the criteria (2,844), less than half (1,011) were less risky than an index fund, and only 15.4% (438) were able to achieve less risk and higher return.
  • Burns then focused just on "large blend" funds, a sample that would more closely match the composition of an S&P 500 index fund. Of the 563 funds that fit in this style category and have been in operation for at least five years, 303 had less risk. Only 12.8% of these funds (72) garnered a higher return while experiencing lower risk.
  • Finally, Burns looked at balanced funds, i.e., funds that invest 60% of their assets in stocks and 40% in bonds. According to Morningstar, there are 477 of these "domestic hybrid" funds with five-year histories. Only 10.5% of actively managed balanced funds achieved the higher return/lower risk nirvana, as compared to the Vanguard Balanced Index fund.

The conclusion: Assembling a portfolio that has a higher return but lower risk than a simple index funds is, in Burns' words, "a statistical long shot." You don't invest in index funds? We can tell you how in 60 seconds. And for some intriguing thoughts on personal finances, check out the Scott Burns website.