A Case for
Index Fund Portfolios
A study of strategy, probability and payout
Richard A. Ferri, CFA, Portfolio Solutions®
Alex C. Benke, CFP®, Betterment
The Shift to Indexing
ICI 2014 Factbook
Scope of the research
• 1976: First S&P 500 indexed mutual fund
– 1992: First US total stock market index fund
– 1995: First US total bond market fund
– 1996: First total international equity fund
• The probability of index fund outperformance
relative to active funds is widely documented.
• Outperformance exists in all asset classes.
• Surprisingly little research compares the
performance of portfolios of index funds with
portfolios of actively managed funds.
Database
• CRSP Survivor-Bias-Free US Mutual Fund
Database through December 2012.
• Covers all active funds and index funds that
were available for purchase over the period.
• Provides a real-world investor experience
when building mutual fund portfolios.
• 32 different index portfolio scenarios; 5,000
randomly selected active fund portfolio
returns compared in each scenario.
Scenario #1: three funds
• 40% US total stock market, 20% total int’l
stocks, 40% US total bond market.
• Vanguard index funds (Investor shares)
– 40% Total Stock Market Index (VTSMX)
– 20% Total International Stock Index (VGTSX)
– 40% Total Bond Market Index (VBMFX)
• 5,000 portfolios from a cleaned database
– No B shares, C shares, annuities, institutional
– Did not include loads, redemption fees or taxes
Results of Scenario #1
Expected results vs. results
Individual Funds &
Indexing
Portfolios (1997-2012)
Win Rate
VTSMX (US equity: 40%)
77.1%
VGTSX (Int’l equity: 20%)
62.5%
VBMFX (US bonds: 40%)
91.5%
Weighted 40%/20%/40%
79.9%
Scenario 1 Results
82.9%
2 out of 3 wins can be a loss
Individual Fund
VTSMX (US equity: 40%)
VGTSX (Int’l equity: 20%)
VBMFX (US bonds: 40%)
Median
Performance
Loss
-2.01%
-1.75%
-0.99%
Median
Performance
Win
0.97%
1.34%
0.23%
1.34%
0.23%
-0.44%
-2.01%
US Equity
International
Bond
Portfolio
Scenario #2: time effect
• Vanguard index funds from Scenario #1
– 40% (VTSMX); 20% (VGTSX); 40% (VBMFX)
• Three independent 5-year periods
– 1998-2002; 2003-2007; 2008-2012
• One 15-year period
– 1998-2012
• 5,000 active fund portfolios per trail
• Does time make a difference?
Time is on the side of indexing
100%
90%
80%
70%
85.8%
83.4%
77.5%
5-yr. average
76.5
66.1%
60%
50%
5-year
1998-2002
5-year
2003-2007
5-year
2008-2012
15-year
1998-2012
Scenario #3: multi-asset class
• 3 fund equal weight (33% each)
– US total stock, total int’l stock, US total bond
• 5 fund equal weight (20% each)
– 3 fund plus REITs and short-term Treasury
• 10 fund equal weight (10% each)
– Large cap US equity, mid cap US, small cap US,
REITs, developed market equity, emerging market
equity, US total bond, short-term Treasury bonds,
inflation-protected securities, tax-exempt bonds.
• 10-year period: 2003-2012
• 5,000 active fund portfolios per trail
More index funds are better
Index
Portfolio
Win Rate
Median
Active
Portfolio
Loss
Median
Active
Portfolio
Win
Three-fund portfolio
87.7%
-1.47%
0.54%
Five-fund portfolio
87.8%
-1.10%
0.44%
Ten-fund portfolio
90.0%
-0.93%
0.29%
Portfolio
Scenario #4: multiple active funds
• Investors often select more than one active
fund in each asset class.
• What effect does this have on probabilities?
• Three-asset-class portfolio from Scenario #1
• 3 trials; 16 years (1997-2012)
– 1 active fund per asset class selected
– 2 active funds per asset class selected
– 3 active funds per asset class selected
• 5,000 active fund portfolios per trial
Bet the farm on one active fund
91.0%
87.1%
82.9%
One Active Fund Per Two Active Funds Three Active Funds
Asset Class
Per Asset Class
Per Asset Class
Scenario #5: risk-adjusted
• Do active portfolios perform better on a
risk-adjusted basis using Sharpe ratios?
• Thee-fund portfolios used in Scenario #1
Time Period
1998-2002
2003-2007
2008-2012
1997-2004
2005-2012
1997-2012
Number of
Years
Index Portfolio
Win %
Risk-Adjusted
Index Win %
5
5
5
8
8
16
66.1%
85.8%
77.5%
75.7%
84.7%
82.9%
64.9%
91.0%
77.7%
74.6%
85.3%
85.5%
Scenario #6: low-fee funds
• Do active portfolios that select funds with
below-average fees perform better?
• Thee-fund portfolios used in Scenario #1
• Lower-cost Admiral shares for index funds
• Active funds selected had expense ratios
below average for their categories.
• 16 years: 1997 to 2012
All funds vs. low fee
6
All active funds
4
Low-fee active funds
2
0
-2
All active funds vs. Investor shares
Index portfolios win: 82.9%
Winning active median: 0.52%
Losing active median: -1.25%
-4
Low-fee active funds vs. Admiral shares
Index portfolios win: 74.7%
Winning active median: 0.54%
Losing active median: -0.99%
-6
-8
0%
10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Highlights
• Index fund portfolios had better performance
nominally and risk-adjusted in all scenarios.
• Winning active portfolio alphas are meager
relative to losing portfolios’ shortfalls.
• Index fund portfolio win rate increased with
time, diversification, and when multiple
active funds are used in asset classes.
• Active fund portfolios benefit from low fees,
but still far below index portfolios.
Where to get the study
Download the PDF from:
• www.RickFerri.com
• www.Betterment.com
For inquires: RFerri@PortfolioSolutions.com
For source code: Alex@Betterment.com
Disclosure
This document and the performance data is provided for information purposes only and should not be used or construed as an indicator of future performance, an offer to
sell, a solicitation of an offer to buy, or a recommendation for any security. Investments are subject to market risk, including the possible loss of the money you invest.
Neither Portfolio Solutions®, LLC nor Betterment can guarantee the suitability or potential value of any particular investment. The performance data used is actual mutual
fund data. The results portrayed reflect the reinvestment of dividends and other earnings, and reflect the deduction of mutual fund expenses. Mutual fund performance can
be found at CRSP Survivor-Bias-Free US Mutual Fund Database. Past performance and portfolio allocations of benchmark indexes, mutual funds, hypothetical portfolios,
or actual portfolios do not guarantee similar future performance of portfolio allocations. No assurances or guarantees can be given or implied concerning future investment
results for Portfolio Solutions®, LLC, Betterment or any investment index. Future returns may differ significantly from the past due to materially different economic and
market conditions and other factors. Investments within portfolios, and therefore, portfolios, involve risk and the possibility of loss, including a permanent loss of principal.
Therefore, no current or prospective client should assume that future performance of any specific investment or investment strategy (including the investments and/or
investment strategies recommended or undertaken by Portfolio Solutions®, LLC or Betterment) made reference to directly or indirectly by Portfolio Solutions®, LLC or
Betterment in its web site, or indirectly via a link to an unaffiliated third party web site, will be profitable or equal the corresponding indicated performance level(s).
Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client or
prospective client’s investment portfolio nor that the future performance of any specific investment or investment strategy will be profitable or equal any historical
performance level(s).
Exposure to an asset class represented by an index is available through investable instruments based on that index. Neither Portfolio Solutions®, LLC nor Betterment
sponsors, endorses, sells, promotes or manages any investment fund or other investment vehicle that is offered by third parties and that seeks to provide an investment
return based on the performance of any index. Neither Portfolio Solutions®, LLC nor Betterment makes assurances that investment products based on the index will
accurately track index performance or provide positive investment returns. A decision to invest in any investment fund should not be made in reliance on any statements set
forth in this document. Prospective investors are advised to make an investment in any such fund only after carefully considering the risks associated with investing in such
funds, as detailed in the offering memorandum, prospectus or similar document that is prepared by or on behalf of the issuer of the investment fund. Inclusion of a mutual
fund, REIT or bond fund within an index is not a recommendation by Portfolio Solutions®, LLC or Betterment to buy, sell or hold such security, nor is it considered to be
investment advice. This document has been prepared solely for information purposes based upon information generally available to the public from sources considered to
be reliable. No content contained in this document (including index data) or any part of the content may be modified, reproduced or distributed in any form by any means,
without the prior written permission of both Portfolio Solutions ®, LLC and Betterment. The content of this document cannot be used for any unlawful or unauthorized
purposes. Portfolio Solutions ®, LLC and Betterment and its third party data provider do not guarantee the accuracy, completeness, timeliness or availability of the content.
Hypothetical illustrations are not exact representations of any particular investment, as you cannot invest directly in an index or fund-group average. Bond funds are subject
to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to
make payments. Diversification does not ensure a profit or protect against a loss in a declining market.
Performance data shown represents past performance, which is not a guarantee of future results. Inherent in any investment is the potential for loss as well as the potential
for gain. Investment returns and principal value will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may
be lower or higher than the performance data cited. Investing involves risk, including possible loss of principal.