A Case for Index
Fund Portfolios
Rick Ferri
Moderator
Founder
Portfolio Solutions
Scope of the Research




Index fund outperformance relative to
active funds is widely documented.
Outperformance exists across all asset
classes.
A portfolio of index funds naturally is
expected to outperform a portfolio of
actively managed funds
Surprisingly little research compares the
performance on portfolios using index to
portfolios using active 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 are
show in this presentation.
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


Three independent 5-year periods



1998-2002; 2003-2007; 2008-2012
One 15-year period


40% (VTSMX); 20% (VGTSX); 40% (VBMFX)
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
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




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 Per
Asset Class
Asset Class
Three Active Funds
Per Asset Class
Scenario #5: Risk-Adjusted


Do active portfolios perform better on a riskadjusted 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 Fund





Do active portfolios that select funds with belowaverage 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 Fund Vs. Low Fee
6
4
All active funds
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
-6
Low-fee active funds vs. Admiral shares
Index portfolios win: 74.7%
Winning active median: 0.54%
-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.PortfolioSolutions.com
www.Betterment.com
For inquires: RFerri@PortfolioSolutions.com
For source code: Alex@Betterment.com
Thank You.
A Case for Index
Fund Portfolios
Rick Ferri
Moderator
Founder
Portfolio Solutions