It’s not a pretty sight. So far this year, the average managed domestic equity fund has been kicking its bogey, the S & P; 500 index, in the teeth. In the first six months of the year, the average manager beat the index by 4.32 percent. Over the last 12 months ended June 30, the gap was even larger 11.61 percent. Indeed, the lagging performance continued in the month of July, with the average fund losing 1.0 percent while the S & P; 500 index lost 1.9 percent. The figures raise some serious questions. Is the heyday of the Standard and Poor’s index funds over? Will Couch Potato investors, who have triumphed through years of carefully applied sloth, finally have to put down their mint juleps, rise from their hammocks, and start the grueling work of picking through the thousands of domestic fund offerings? The answer to both questions: probably not. But the immediate future may not be as rosy as the last 15 years. Let me tell you why. The case for indexing is intact. Indexing started in the mid-’70s when researchers noticed that professional managers, as a group, regularly failed to beat the S & P; 500 index. Studies showed that about 70 percent of all managers would trail the index. There was great puzzlement over how so many smart people could fail to beat a dumb index. The answer, then, was costs. Even though the costs of running large institutional pension accounts the accounts that dominated the investment world at the time were small compared to the typical mutual fund, research indicated that professionals could not outrun the combination of their fees and the costs of transactions. Today, the cost of a retail mutual fund is higher than the cost of running a large institutional pension account was then, and portfolio turnover rates have soared. As a result, the overall cost of running a managed account has increased. Bottom line: The cost advantage that gave passive investing its edge is still in place. In spite of that, it will be difficult for S & P; 500 index funds to repeat their performance advantage of recent years. One reason is that the index beat more than 75 percent of professionals in its category in each of the years between 1994 and 1998, as new investors flooded into the market, buying visible names. It hasn’t been below the 50th percentile against other managers since 1990. This is a very rare event. How rare? Put it this way, among the well-recognized funds that have done better than the index, most have been in the top 25 percent of their category only two or three years in a row. Yes, we’re talking about funds like Janus Twenty, Fidelity Growth, AIM Constellation and Vanguard Primecap. The most likely future is one in which the S & P; 500 index funds rank in the second quartile rather than the top quartile, as stocks outside the index do better than stocks inside the index. In other words, instead of only one in five funds beating the index, it may be one in three. Picking a better fund will be less of a long shot but it will still be against the odds. Is there a simple but still passive way to cope with the shift? Indirectly, yes. The S & P; 500 index accounts for 75 to 80 percent of all market value in America. You can dilute but only dilute a period of relative underperformance by owning shares of a broader index. Question: My husband and I are in our early 60s and are retired. We recently attended a seminar that exposed us to IRS 72(e), which would allow us to shelter all interest income, including our IRAs, from Social Security taxes until we draw out the monies. It also does away with the rule that you must withdraw at 70 years of age and is insured to $1 million. To use this rule, we would have to place our money in a variable annuity offered by Golden American Life Insurance Co. Supposedly, we would still be in control of our IRAs and other monies turned into a special annuity that is protected from government taxing of our Social Security benefits. The gentlemen who came to our home said he had to have four licenses to be able to offer this to us, and that not many people were willing to secure them in order to work with people on this basis. He also said this rule protects our money from litigation and bankruptcy. We did not discuss managerial fees. Since we have never heard of this rule in all the retirement/IRA seminars that we have attended in preparation for retirement, we are not sure if what he is telling us is valid. We are puzzled. I am enclosing the brochure and other materials. G.D., Dallas Answer: The brochure, printed by Senior Benefits of America Network, is titled “How to Avoid the Taxing of Social Security Income.” It states: “Let’s say you have a $100,000 IRA in a mutual fund that you are not touching. Let’s say it earned 10 percent last year, or $10,000. You don’t need the money and you reinvest the dividends and capital gains. The IRS will still count that income against you when evaluating the Social Security tax!” (Underlined in brochure.) In fact, the brochure is wrong. Earnings inside an IRA account whether dividends, interest or capital gains are not taxable. Money from IRA accounts is taxed only on withdrawal. Further, the marketing brochure says that only a “deferred annuity, fixed or variable, when registered under Internal Revenue Code 72(e) is exempt from Social Security taxation.” This is also balderdash. As with an IRA account, a tax-deferred annuity allows you to defer taxes until you withdraw money at a later date. It does not exempt them. Calls and faxes to Senior Benefits of America Network were not returned. The compliance officer for Golden American Life Insurance had no comment before seeing the document and then did not return phone calls. Whether this is a case of ignorance or misrepresentation, what we’ve got here is a sales seminar pure and simple. The salesmen did not discuss fees because the cost of their product is worse than the tax burden they offer to “protect” you from. Now let’s try a specific example. Suppose that you had invested in a GoldenSelect variable annuity five years ago. What would your return have been? Their limited maturity bond fund sub-account earned 4.09 percent a year, net of fees. With fees like that, who needs to worry about the taxman? Worse, any accumulated income would still be subject to taxes when it was withdrawn. Vanguard GNMA, a low expense, no-load fund frequently mentioned in this column, earned 6.52 percent annually over the same period. A five-year Treasury earned at a 6.01 percent rate over the same period. Questions about personal finance and investments may be sent to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; or by fax: (214) 977-8776; or by e-mail: email@example.com. Check the Web site: www.scottburns.com. Questions of general interest will be answered in future columns.
PERSONAL FINANCE—Managed Funds Holding a Big Lead Over Major Index