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Why Avoid Index Investing?

Sat., Jan. 31, 1998

January traditionally brings a rush of cash into mutual funds. Most of it will be invested in actively managed equity funds that, based on the results of the last four years and 16 of the last 28 years, will struggle to beat the S&P; index in 1998.

Considering the compounding of investment returns over the long term, a persistent shortfall by actively managed funds, with their higher fees, can be costly to investors compared with low-cost index funds.

Ironically, the thousands of smart and nimble professional portfolio managers who buy and sell stocks for actively managed funds provide the brainpower and market liquidity that allow index investing to work.

Three professors - Sanjai Bhagat and Donald Lichtenstein of the University of Colorado and Patrick Kaufmann of Georgia State University - surveyed academic research into mutual-fund-buying behavior and reached some unsettling conclusions.

Why do actively managed funds grow and prosper, despite unassailable evidence that a simple and low-expense index fund is the best bet for most investors? The three scholars offer several explanations:

Investors fail to evaluate their mutual fund returns against the S&P; or any other broad market benchmark. Many compare their fund return to yields on bank savings accounts.

In the last three years, the average return of the S&P; 500 index has been so extraordinary - roughly 30 percent per year - that funds performing well below the S&P; average still seem good. The opportunity cost of underperforming a low-cost index fund is not so apparent.

Some investors are unsure of themselves and inclined to believe that if they pay for brokerage services and active fund management, they must be getting a benefit from Wall Street experts. These investors may be paying to have friends.

Most investors believe, despite ample warnings to the contrary, that past results predict future performance.

Investors enjoy taking risks and having interesting stories to tell about their investing, stories not provided by passive index fund investing.

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