Andrew Allentuck

Monday, December 2, 2002

All About Index Funds: The Easy Way to Get Started
by Richard A. Ferri
McGraw-Hill, 2002
275 pages
ISBN 0-07-138705-6

Index funds are tradable bundles of stocks sold as hybrid units that have the advantage of closed end funds in that they hold known securities and the advantage of open ended funds in that they are priced at the net asset value of their holdings. One-time U.S. Marine pilot and, later, a stock broker, Richard A. Ferri has written a brilliant book about their organization, operation and strategic function in investment portfolios. His point is that index funds have lower asset turnover than managed funds, are more tax efficient, have much lower management fees, and tend to outperform managed funds over long periods.

Unlike most mutual fund books that say that by tracking performance of various portfolios, investors can spot winners, All About Index Funds notes that actively managed funds have a poor chance of beating passively managed index funds. Differences in management expense ratio account for a lot of that difference. In Canada, for example, the average MER on equity funds is about 2.4 per cent. Some index funds do their management on a tenth of that fee. Add it up. Over 10 years, the managed fund will take 25 per cent of your original contribution, give or take, while the index fund will only nick it for 2.4 per cent, give or take.

Are managers worth their fees? That's hard to say. Relative performance data tends to say no. What's more, though Mr. Ferri does not discuss it, luck or randomness plays a large part in who wins and who loses. Some managers are just lucky and some of those lucky ones can be persistently lucky without any reason to explain their good fortune. Others are either unlucky or have a gift for bad stock picking. Statistically, it is hard to identify those lucky or unlucky managers. Index funds let one step out of the game of trying to pre-pick the winner in the casino, but, at the same time, they fail to answer the essential question: is there a return to intellect?

Warren Buffett, the sage of Omaha, is quoted twice in the book but Mr. Ferri does not question his success as an investor as an example of what brains can earn. It's just as well, because Mr. Buffett is not a passive investor. He actively manages his gaggle of companies from a furniture store to a candy maker, soda pop, transportation and much more. The conventional investor with some stocks or bonds or mutual funds cannot manage anything and has hardly any influence in corporate governance.

Let's say, as Mr. Ferri acknowledges, that there may be a return to intellect. Still, as investor Charles Ellis pointed out in Winning the Loser's Game (which Mr. Ferri quotes) since 85 per cent of funds fail to do as well as indices, it hardly pays to try to find them. Further, once one discounts luck and applies some math to try to find significant outperformance over indices, the residual group of great performers is tiny. Then there is the winner's curse, which tends to make any period's outperformers the underperformers of the next period. The implicit question in all this can be summed up in one rhetorical question: "why bother?"

Still, for short periods, managed funds, leveraged funds, reverse leveraged funds that go up more than proportionately to a market's decline, sector funds, theme funds, and style funds can beat indices. Timing the market is hard and, one would have to say, timing the best periods to buy into, say, a value oriented energy fund or a growth-based biotech fund is even tougher. That's like trying to predict the styles of next year's ridiculous Paris fashions. The rational investor should give up and stick to basics, like betting on entire markets via index funds.

All About Index Funds is American content, but the Canadian reader can disregard discussions of 401-k plans and 12-b fees and stick to the argument for indexing. There is hardly a better compact discussion of the origins and growth of the industry. As a provocative read and as a reference work, Mr. Ferri has produced a work that is simply superb.