Saturday, March 17, 2007

New Research from Journal of Financial Planning

Improved Study Finds Index Management Usually Outperforms Active Management

by Millicent Holmes

Executive Summary

This study seeks to improve in several ways upon previous studies examining the relative performance of index management versus active management. It concludes that index management outperforms active management in most asset classes.

  • To make comparisons between index management and active management as accurate as possible, the study segregated funds by style and then compared funds of the same style. This "apples to apples" comparison is the most accurate methodology. Many other studies suffer from some level of benchmark mis-specification or "size bias," as they compare all actively managed funds, which include Large-, Mid-, Small-, and Micro-cap funds to a Large-Cap Blend index, the S&P 500.
  • Many studies on indexing versus active management have used only gross returns, which tend to overstate active manager fund performance. By contrast, this study examines fund performance net of management fees, expenses, and the impact of taxes.
  • Also, these studies typically have used commercial mutual fund databases as their investment universe. Unfortunately, all commercial databases suffer from survivor bias, overstating the returns for the universe of active managers that have survived to the present date. This study uses "survivor-biased minimized" data to help solve this difficulty.
  • In general, index management outperformed active management in the Large-Cap Blend, Value, and Growth asset classes. The results in Mid-Cap were mixed, with active Mid-Cap Value outperforming index management for most periods. Active management also outperformed in active Small-Cap Blend and international Mid/Small-Cap Blend.
  • Surprisingly, indexing outperformed active management in the active Small-Cap Value and Growth asset classes, precisely the asset classes in which one would expect active management to outperform index management.

Millicent Holmes is director of research at Brownson, Rehmus & Foxworth Inc., a firm in Chicago, Illinois, that offers comprehensive wealth management, including investment consulting and multi-family office services. Her past experience includes working with fund of hedge fund managers, developing alternative investment products for international institutional investors in the United States and abroad, and trading options from the floors of the Chicago Board of Trade and Chicago Mercantile Exchange.


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