• Professional money managers operate as the experts in the field of investments. They are supposed to be better informed, smarter, have lower transactions costs and be better investors overall than smaller investors.
• The earliest study of mutual funds by Jensen suggested that this supposition might not hold in practice. His findings, summarized in Figure 9.24, as excess returns on mutual funds, were that the average portfolio manager actually underperformed the market between 1955 and 1964.

The same holds true for bond funds as well...

More Findings on Money Managers

• These results have been replicated with mild variations in the conclusions. In the studies that are most favorable for professional money managers, they break even against the market after adjusting for transactions costs, and in those that are least favorable, they underpeform the market even before adjusting for transactions costs.
• These findings are not sensitive to how risk is measured and seem to be robust to alternative definitions of risk. For instance, the following graph summarizes the percentage of money managers who underperformed the market in each year from 1971 to 1993.

• The results, when categorized on a number of different basis, do not offer much solace. For instance, Figure 9.25 shows excess returns from 1983 to 1990, and the percentage of money managers beating the market, categorized by investment style.

Performance by Management Style

• Money managers in every investment style underperform the market index.

Performance of Mutual Funds relative to S& P 500: Classified by investment style and fund size

	Value	Blend	Growth
Large Funds	-1.3%	-1.4%	-1.0%
Medium Fund	-2.8%	-1.5%	-3.0%
Small Funds	-1.0%	-1.8%	-1.3%

• Capitalization: >5 Billion: Large 1-5 Billion: Medium <1 Billion: Small
• Value: PE or PBV less than S& P 500; Growth: PE or PBV higher; Blend: Close to Average

Payoffs to Active Management

• Figure 9.26, from the same study, looks at the payoff to active portfolio management by looking at the added value from trading actively during the course of the year and finds that returns drop from 0.5% to 1.5% a year as a consequence.

Continuity of Performance

• Finally, the study, like others before it, found no evidence of continuity in performance. It classified money managers into quartiles and examined the probabilities of movement from one quartile to another each year from 1983 to 1990. The results are summarized in Table 9.7.

Table 9.7: Probabilities of Transition from One Quartile to Another

	Ranking next period
Ranking this period	1	2	3	4
1	26%	24%	23%	27%
2	20%	26%	29%	25%
3	22%	28%	26%	24%
4	32%	22%	22%	24%

These results make the case for Index Funds..

What is an Index Fund?

An index fund attempts to replicate a market index. It is relatively simple to create, once the index to be replicated has been identified.

1. Identify the index to be replicated. (Example: S & P 500)

2. Estimate the total market values of equity of all firms in that index.

3. Create a market-value weighted portfolio of stocks in the index.

This fund will replicate the index and is self correcting. It will need to be adjusted only if stocks enter or leave the index.

Why Index Funds?

Index funds are less expensive to create - there are no information costs and no analyst expenses - and less expensive to run - minimal transactions costs and management fees. They cannot, however, beat the market index.

Type of Fund Transactions Costs

Index Fund 0.20%-0.40%

Active Value Fund >1.30%

Active Growth Fund >1.75%

Index Funds also create less tax liabilities

But don't active managers time markets better than index funds?

It is true that during bear markets, active money managers do better than index funds..

But they stay in cash too long..

When should you use Index Funds?

If the cost to active money management exceeds to payoff to active money management, an index fund is a better choice for investors.

• There is substantial evidence of irregularities in market behavior, related to systematic factors such as size, price-earnings ratios and price book value ratios.
• While these irregularities may be inefficiencies, there is also the sobering evidence that professional money managers, who are in a position to exploit these inefficiencies, have a very difficult time consistently beating financial markets.
• Read together, the persistence of the irregularities and the inability of money managers to beat the market is testimony to the gap between empirical tests on paper and real world money management in some cases, and the failure of the models of risk and return in others.
• The performance of active money managers provides the best evidence yet that indexing may be the best strategy for many investors.