ERTAINLY YOU'VE HEARD IT: "Over time, the majority of actively managed equity funds falls behind the unmanaged index." This is the mantra of the index fund investor. Depending on the time period and index, the amount of underperforming managers goes from 50% to 70%, or perhaps even higher.

If you own any funds that have underperformed the index or if you've come up short in your stock portfolio, you may be ready to throw in the towel. But before you do, take a closer look at the unmanaged index that's beating you.

For example, while there's no denying that the S&P 500 bested many funds in the decade of the '90s, it's just not true that it's an unmanaged index -- at least as most folks would define "unmanaged".

You might have a different idea, but we'd define an unmanaged index as a set basket of stocks. Once it's established, it's left alone. Stocks aren't added or subtracted to change the overall composition or juice up performance. Instead, changes only occur when necessary to replace stocks of acquired or delisted firms.

None of the major indexes work like this and that's why the indexers' argument isn't as convincing as it first appears. There are two main reasons for this.

About that Turnover

Index Turnover Rises…

Source: Standard & Poor's The smaller the capitalization of the index, the greater the number of company changes. Also turnover in all indexes is on the rise. Is this your idea of unmanaged?

To see this, lets take a look at the S&P indexes. Everybody knows about the S&P 500, the large cap index. There's also the S&P 400, a mid cap index, and the S&P 600, a small cap index. The nearby chart shows the company changes for each index from 1995-1999.

There's a couple of things to notice here. First, the trend for all indexes is up. Second, in each year, the large cap index has the fewest changes, the mid cap has more, and the small cap index has the most. This is understandable since companies grow in size and "graduate" from the small to mid cap index, and similarly from the mid cap to the large cap. But once they get to the 500, they stick around since there's nowhere else to go.

The turnover level rivals that of many actively managed funds. When it's cap-weighted, the mid and small cap indexes exceed 20% -- and that's on the rise. Many value managers (or individuals using a value approach) have far less turnover than this.

…From Already High Levels

5-Year Average Turnover S&P Index Annual Cap-Weighted S&P 500 Large Cap 7.12% 6.03% S&P 400 Mid Cap 13.15% 21.62% S&P 600 Small Cap 12.80% 20.14% Source: Standard & Poor's The average turnover for the mid and small cap indexes are even higher when they're cap-weighted. As you would expect, this implies it's the larger companies that are moving. At 20%+, these turnover rates are higher than many active managers -- especially value managers.

Which brings to mind the second issue: If all this turnover is occurring, what's being added and what's being taken out?

A Shift to Growth

According to S&P, there are several factors they consider when selecting stocks for an index. First, they want the stock to be liquid to facilitate trading without inordinate price changes. Second, they look for companies that are profitable and/or have stable balance sheets. In other words they don't want to add companies with questionable futures. Why add it when it may shortly disappear on its own?

The final criterion is the most interesting of all: S&P seeks to align their indexes with economic and market conditions. This is why departing stocks are often not replaced with stocks from the same sector. This is also another example of active management.

The Growth of Growth S&P 500 Cap-Weighted Sectors

Sector 1964 1999 Consensus Long-Term Growth Rate Basic Materials 16.5% 3.7% 11.49% Capital Goods 8.5% 8.0% 12.6% Consumer Durables 11.3% 1.9% 10.8% Consumer Nondurables 10.0% 9.9% 13.4df% Consumer Services 6.3% 12.6% 14.8% Energy 17.8% 5.8% 9.3% Finance 0.0% 14.8% 12.9% Health 2.3% 11.8% 15.0% Technology 5.5% 19.0% 21.2% Transportation 2.6% 1.0% 10.3% Utilities 19.2% 11.5% 9.9% Source: Goldman Sachs, IBES The S&P 500 has quietly become a growth index. Over the past 35 years, sectors with the highest growth rate have gathered additional weight while those with the lowest growth rates have seen diminishing emphasis. In a period of growth outperformance, is it any wonder value investors have had a hard time keeping up?

To see why, just take a look at the nearby table comparing the 1964 sector weighting or the S&P 500 to the 1999 composition. Traditional growth areas such as technology, healthcare, and financials show double digit increases while cyclical sectors such as consumer durables, basic materials, and energy show equally large decreases.

In light of this, it's no wonder value managers have struggled to keep pace with the 500. Over the past decade, growth stocks have outperformed value stocks. This isn't unusual since these styles periodically come into and go out of favor. What is important however, is the fact that the S&P 500 has become a growth index, so it isn't a true benchmark for value portfolios.

This isn't just sour grapes because growth has bested value. It will still be true when the trend reverses itself and value outperforms the 500.

What you should take away from this is the realization that the S&P Indexes aren't passive benchmarks. Perhaps the best description is to think of them as actively managed growth indexes. Once you recognize that, it's no wonder buy-and-hold or value portfolios don't match their returns. Why should they?

A House (and Senate) Divided

"It is the duty of the President to propose and it is the privilege of the Congress to dispose."

-- Franklin D. Roosevelt

 

S ELECTION DAY APPROACHES, YOU'LL HEAR more and more about the consequences of either party's victory. More specifically, there'll be a lot of speculation regarding which candidate will be best for investors and how the market will react following the election.

Generally election years have been fairly kind to the financial markets. Perhaps it's all the promises being made or just a hope for positive changes. Some of the best performance comes in the latter part of the year when the uncertainty of the election has passed.

On the other hand, the first year of a new president's term is usually one the of the worst. That may stem from the fact that new leaders often attempt to implement new and untested plans. Uncertainty always spooks the market.

Party Favors

This year, many republicans are campaigning on a tax cut, promising to leave more in your pocket after April 15. Democrats oppose this,

When the republican congress called for tax cuts, the democrat president vetoed them. When the president threatened us with Hillary Care, congress killed it.

contending that excess tax collections are best used to reduce the national debt.

Either way, investors would win. Certainly we're better stewards of our own wealth than the government. Tax cuts would grant us greater use of our own funds, which presumably, would find their way back into the market. By the same token, a smaller national debt would help stabilize the economy, not only for this year, but for years to come. A stable, non-leveraged economy offers greater future growth opportunities. Again, this is good for the financial markets.

What We Had, What We Got

Throughout the 90's, a period of tremendous non-inflationary economic growth, we had a president from one party and a congress from another. Mercifully, we had no fiscal policy.

When the republican congress called for tax cuts, the democrat president vetoed them. When the president threatened us with Hillary Care, congress killed it. Each party offered a lot of rhetoric supporting their agenda, but when all was said and done, no major measures were ever enacted.

The decade of he 90s was the first in quite some time without any real fiscal policy. The boom of the 1960s ended in deficit spending to fund the

We need a president from one party and a congress from the other.

Vietnam War. We paid for that with Nixon's wage and price controls and Carter's stagflation. Reagan's tax cuts and defense spending stimulated the economy, but only at the expense of greater deficits.

It took the last decade's lack of fiscal initiatives to allow the economy to begin to heal. Without fiscal policy to offset it, the Fed's monetary policy actually had a chance to work. It's surprising that communists haven't drawn attention to the fact that the appointed Fed is much better at guiding the economy than the peoples' elected officials.

A Modest Desire

With all this as a background, the best alternative is pretty obvious: We need a president from one party and a congress from the other. It doesn't matter which party has which role, as long as the government remains divided. That way we may be blessed with at least two more years of gridlock, letting the markets and the economy alone.

The free market system will always be better than politicians -- even the best politicians money can buy.

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