Another Reason to Feel Good
About Index Funds

If you're like me (a favorite opening line of copywriters), you may have felt a twinge of regret about the fact that three of the four stock funds in our 401(k) plan are index funds.

Sure, index funds provide the closest thing you can get to a guarantee of above-average returns over the long haul. And yes, the Vanguard Index 500 has outperformed three-quarters of US stock funds over the last ten years. But even so, there are hundreds of funds that have done even better. Wouldn't it be nice to have been in one of those?

I admit to having these feelings myself. And although I'm skeptical about the fund ratings that are published by Fortune, Money, Worth, and so on, I was pretty sure there was one place where you could find actively managed funds that would do even better than index funds: the Forbes Honor Roll.

Forbes has been rating mutual funds for 40 years, and by now they have it down to a science. Unlike some of the other rating systems, Forbes places a lot of emphasis on fund expenses and on risk factors, including how the fund has done, or can be expected to do, in a bear market.

The Forbes Honor Roll includes only about two dozen stock funds out of the thousands available. The funds, both domestic and international, are selected on the basis of sustained long-term results achieved with low expenses and under the same management. The 1995 Honor Roll includes such legendary names (in the fund biz, anyway) as Mutual Beacon, Mutual Qualified, SoGen International, New York Venture, and T. Rowe Price International Stock, which has been on the Honor Roll for six years running (I have some money in it myself).

All this explains why I was so startled when I saw a graph in Vanguard's Retirement Investing Guide showing that the funds on the Forbes Honor Roll had actually underperformed the average US stock fund! Vanguard calculated what your returns would be if you invested equal amounts in the funds on each year's Honor Roll, making changes as the list was updated. The average annual return over 20 years for the Honor Roll was 11.2%, compared with 12.5% for the average stock fund, and 13.1% for the stock market as a whole.

How can this be explained?

One likely reason is that buying and selling new Honor Roll funds each year would run up expenses, especially when you pay a load to get into (or out of) a fund. Another is that studies have shown that the performance of funds has a strong tendency to revert to the mean. By the time a fund has done well enough to be identified as a winner, it may be ready for a slump. Whatever the reason, the bottom line is that, over time, it's very, very difficult to beat a low-cost, no-load index fund.

Published in Bread and Cutter, April 1996.