March 2000


By William E. Fender and Brian P. Cunningham

Investors spend a considerable amount of time, money, and effort trying to outperform widely published stock market indices, such as the Standard & Poor's 500 Index. Unfortunately, when costs and taxes are factored into the equation, the probability of success dwindles to percentages that are less than many scratch-off lottery games.

Standard & Poor's 500 Index

The S&P 500 Index has a long history, dating back to 1923, when Standard & Poor's introduced a series of indices that included 233 companies. The S&P 500 Index itself was introduced in 1957 and was the original proxy for testing a capital asset pricing model used to predict the relationship between the risk of an asset and its expected return. The goal at the time was that the S&P 500 Index should reflect how investors actually invest in equities. Some 40 years later it continues to meet that objective; the 500 stocks in the index represent in excess of 70% of total U.S. stock market capitalization. This is quite remarkable, considering that there are almost 8,000 U.S. stocks in Standard & Poor's database. As of April 30, 1999, the index represented nearly $11 trillion in market capitalization.

Due to the capitalization weighting of the index, it is a good benchmark for the domestic, large-capitalization style of investing. Currently, the average market capitalization of companies in the index is $21.8 billion and the median, the point at which the index could be split into two equal pools of 250 stocks, is $8.37 billion. As has been the case since the index's inception, the bulk (approximately 50%) of the capitalization is concentrated in the top 50 stocks.

Most investors do not know how the index is constructed. Companies are not chosen based solely on market capitalization, sales, or profits. Rather, Standard & Poor's goal is to choose leading companies in leading industries within the U.S. economy. In 1968, the index was added to the U.S. Department of Commerce's Index of Leading Economic Indicators. The S&P 500 Index has grown over the years to become the de facto benchmark for professional money managers.

Finally, unlike other large-cap indices, Standard & Poor's does not prematurely remove outliers (i.e., stocks that falter or become relatively small) from the S&P 500 Index, thereby reducing portfolio turnover. Minimal portfolio turnover and low dividend yield reduce the tax impact and result in extremely high tax efficiency (discussed in detail below). Furthermore, the index is relatively easy to replicate and has become quite popular, as witnessed by the massive growth in assets in the Vanguard S&P 500 Index mutual fund. This fund has grown from just over $1 billion at year-end 1988 to approximately $70 billion at year-end 1998. The result is that the index is truly a readily available and widely used passive alternative to active money management.

What Does an Active Manager Need to Match the S&P 500?

The first step in the analysis was to estimate the percentage of total return that is typically retained, after taxes, by the investor. Mutual funds were chosen due to the reliability of the return figures and the fact that mutual fund returns are net of fees. Using the Morningstar Principia Pro mutual fund database, the universe of mutual funds was screened to identify only large-cap products. Next, index, specialty, sector, or international funds were eliminated from the analysis. Finally, the universe was limited to mutual funds that had a minimum 10 years of tax-adjusted data. This screening resulted in 307 funds with the data necessary to estimate the average mutual fund's tax efficiency.

For each of the 307 funds, the tax-adjusted return was divided by the load-adjusted return for the 3-, 5-, and 10-year periods ending April 30, 1999. The tax-adjusted return shows a fund's annualized after-tax total return, excluding any capital gains effects that would result from a sale of the fund. To determine this figure, all income and short-term capital gains were taxed at the maximum Federal tax rate of 39.6%. Long-term capital gain distributions were taxed at 20%. The after-tax amount was reinvested in the fund, and state and local taxes were ignored. Tax efficiency was calculated by dividing the after-tax total returns by load-adjusted returns, which are pre-tax total returns. The five-year average tax efficiency for the large-cap mutual funds was calculated to be 88.3%.

The final step was to calculate the total pre-tax return that would have been required for a mutual fund to produce an after-tax return that equaled the S&P 500 Index returns. Twenty years of quarterly data for the S&P 500 Index were adjusted by the five-year average tax efficiency percentage. To gross up the return, the rate of return for the S&P 500 Index for each quarter was divided by 88.3%. This resulted in the pre-tax return an active manager would have had to earn to equal, after taxes, the S&P 500 Index. For example, the S&P 500 Index return for the three years ended December 31, 1998, was 28.23%. Dividing that return by the five-year average tax efficiency ratio results in a pre-tax return (hereafter, the pre-tax return requirement) of 32.18%.

Pre-Tax Return Requirement vs. Large-Cap Universe

The pre-tax return requirement was then compared to a universe of large-cap mutual funds to determine what ranking a mutual fund would have attained if it had generated those returns. Universe comparisons were compiled by Callan Associates, Inc., and represent a relevant sampling of large-cap mutual funds. Rankings were calculated over three distinct time period distributions (cumulative, annual, and rolling periods). The goal was to eliminate any recent period bias.

Cumulative Return Periods. The results for 3-, 5-, 7-, 10-, 15-, and 20-year cumulative periods ending December 31, 1998, are illustrated in Exhibit 1. This analysis clearly indicates that even in the best case for mutual funds (the 20-year period), less than 7% of large-cap mutual funds would have provided sufficient pre-tax returns to outperform, after taxes, the S&P 500 Index. In the worst case (the 15-year average), less than 1% of large-cap mutual funds would have outperformed the index. In all remaining periods, less than 5% of large-cap mutual funds would have provided sufficient returns to outperform, after taxes, the S&P 500 Index. Regardless of the period, it is painfully obvious that an investor had roughly a 1 in 15 probability of picking the mutual fund that would have provided after-tax returns equal to the S&P 500 Index.

It is, of course, relatively rare for an investor to stay with a particular money manager for more than a few years. As a result, the investor substantially increases their taxable burden and decreases the benefit of tax deferral. Therefore, it is extremely important to note that the tax efficiency calculations on which these comparisons are based do not account for the sale of the fund, only for dividend and capital gain distributions. The S&P 500 represents a single investment that would have been held throughout the entire period and not sold. For an investor to equal the index performance, she would have had to select a single, truly exceptional performing mutual fund at the outset and hold it throughout the entire period.

Calendar Years. Next, each individual calendar year, beginning with 1979 and ending with 1998, was examined. Mutual funds would have had to place in the percentiles shown in Exhibit 2 to equal, after-tax, the returns of the S&P 500 Index.

Mutual funds could have been below median in only 4 of the 20 calendar years for their after-tax return to equal the S&P 500 Index. An investor would have had to pick a fund or manager that was above median (and in most years, well above median) in 80% of the calendar years. Since a high percentage of managers are not above median in even half of the single year periods, this would be quite an accomplishment.

Rolling Five-Year Periods. Finally, many skeptics of passive investing claim that indexing is a recent fad and once a poor market cycle occurs active managers will add substantial value. They argue that the bull market of the '90s masks the terrific performance that active managers had in the '80s. As a result, the third part of this study analyzed the pre-tax requirement over rolling five-year periods, again going back 20 years. In other words, the five-year periods ending December 31, 1983, March 31, 1984, June 30, 1984, and so on, through December 31, 1998, were examined. In all, 61 rolling five-year periods were analyzed.

Exhibit 3 illustrates the result of the rolling five-year analysis. It depicts the frequency of the rankings of the pre-tax return requirement. For example, there were 19 five-year periods when the pre-tax return required to equal the S&P 500 would have placed the mutual fund in the top 10% of its peer group. There were another 19 five-year periods when the pre-tax requirement would have placed the mutual fund between the 10th and 20th percentiles of its peer group, eight periods between the 20th and 30th percentiles, and so on.

Again, it's clear that it would have been very difficult for an investor to pick a mutual fund that provided enough value to outperform, after taxes, the S&P 500 Index. In fact, the average five-year ranking required by a mutual fund would have been the 19th percentile. The pre-tax required return fell below the median mutual fund in only 3 of the 61 periods, all of which occurred before June 30, 1984.

No matter how the investor "slices and dices" the results, it is clear and highly unlikely that she could choose a mutual fund that would perform well enough, year in and year out, to equal or exceed, after taxes, the S&P 500 Index passive approach.

Why Bother?

With all of this data in mind, the validity of a taxable investor utilizing active management for the large-cap domestic equity portion of a portfolio must be questioned. Maybe active management thrives for the same reason that people participate in the lottery or sweepstakes.

Unfortunately, the answer is not quite that simple, and there are numerous other factors. These include excessive "noise" about financial markets in the media and the powerful marketing of Wall Street. Couple these forces with findings in the field of behavioral finance (e.g., investor overconfidence in investment decisions), and it's not surprising that investors are not satisfied with the "average" performance of the index. After all, the S&P 500 Index is just another measure of the average stock--isn't it?

As noted earlier, investors fail to realize that Standard & Poor's has well-defined standards, not the least of which is that a company should be considered an "industry leader." Therefore, active managers must pick better industry leaders than Standard & Poor's. Moreover, they must be adept enough to make up for the higher fees and tax consequences of frequent trading. The data simply does not support a conclusion that active management can achieve that objective.

It is important to note that this analysis was only applied to large-cap domestic equities and draws no conclusions toward domestic small-cap equities or international equities. Nevertheless, investors will frame decisions depending upon their needs and desire to rationalize an otherwise irrational decision. Those that are truly interested in building their net worth and maximizing after-tax returns should consider a passive approach for at least a portion (large-cap stocks) of their portfolio. *

William E. Fender, JD, CPA, is a senior investment consultant and
Brian P. Cunningham, CFA, the chief executive officer, at Innovest Portfolio Solutions, Inc., Englewood, Colo.

Adapted with permission from The Journal of Private Portfolio Management, Winter 1999. All rights reserved.

Milton Miller, CPA

William Bregman, CPA/PFS

Contributing Editors:
Alan J. Straus, LLM, CPA

Mitchell J. Smilowitz, CPA
Gallegher Benefit Services of New York

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