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The Secret You Need to Beat the Market

Fact: Index fund investors tend to do better than investors in actively managed funds.

Want evidence? According to Mercer, in the year to March 2011, the median fund returned 2.8%, less than the 3.8% return by the S&P/ASX 300 index.

Is this because most fund managers can’t seem to get their acts together and beat the indexes? That’s part of it. Is it because of the sometimes staggering fee differential between actively managed funds and passively managed index funds? That’s definitely a big factor.

But the bottom line is that it doesn’t much matter what kinds of after-fee returns actively managed funds are able to produce — the sad fact is that most investors in those funds typically end up with significantly worse returns than what the fund actually generates.

A 2007 study by Zero Alpha Group (ZAG) showed that, on average, U.S. index fund investors tend to lag the returns of their funds by 0.47% per year, while investors in actively managed funds lag by a whopping 1.7%.

While 1.7% may not sound like a lot, consider this: Over the course of 30 years, $250,000 turns into $4.36 million with 10% returns, but it reaches only $2.73 million with 8.3% returns.

Does $1.6 million strike you as something worth paying attention to?

No fluke

ZAG’s study is hardly some wonky view that may or may not hold water. The tendency for fund investors to underperform the funds they invest in is no big secret. The knowledge of this is so strong that it spawned a legend that half of the investors in Fidelity’s U.S. Magellan Fund during Peter Lynch’s tenure — which produced 29% average annual returns — actually lost money.

Though the Lynch/Magellan story may be apocryphal, the lesson from the real studies that have looked at this tendency is something that every investor needs to brand their grey matter with.

In simple terms, fund investors underperform their funds because they are terrible at timing the market. They buy during ebullient times when everything’s frothy and then have a tendency to sell when panic is in the air and blood is running in the streets. Buy high and sell low is always a recipe for disappointment.

But why doesn’t this happen to index fund investors to the same extent? It’s because, for the most part, they don’t bother trying to time the market.

By investing in index funds in the first place, this set of investors has basically said, “I give up, I’m just going to take the market’s returns and call it a day.” So it’s not all that surprising that they don’t bother hopping in and out of their investments.

Indexes aren’t perfect

There are however drawbacks to investing in indexes. For one, most of the major ones weight the holdings based on size, so the bigger a company gets — regardless of whether that comes from profit growth or a runaway valuation — the more of it the index will own.

Right now, BHP Billiton (ASX: BHP) makes up over 13% of the S&P/ASX 200 index, and the top 10 constituents, including the big four banks and the two dominant supermarket retailers — Woolworths (ASX: WOW) and the Wesfarmers (ASX: WES) owned Coles — make up over 50% of the same index.

Investors thinking that a 200-stock index would give them good diversification may not realise how much their investment was set to live and die on the fortunes of just a few companies in even fewer sectors.

In addition, by their nature, indexes invest in everything within certain bounds. So if you buy an S&P/ASX 200 index fund, you’re getting shares of Qantas (ASX: QAN) even though as a rule you may not invest in airlines.

When it comes to investing, we prefer to pick out individual shares that have more attractive characteristics — lower valuation, higher dividends, better business — than the average index fund holding.

Patience: Not just for index funds

Over the years, many large, well-known companies have produced very impressive dividend-adjusted returns.

Of course it’s been anything but a straight line for shares over the past decade or more, and there were plenty of opportunities for investors to buy high, sell low, and shoot themselves in the foot.

But what if we approached investing in individual companies the way index fund investors view their investments? Granted, when it comes to individual companies you can’t ignore significant changes in the business that make it unattractive.

But what happens when you shut out your full-service broker and the media circus and hang onto a high-quality stock for years and years, if not decades?

The missing ingredient

As is usually the case, we could do worse than using Warren Buffett as an example. Twenty years ago, Coca-Cola, Gillette (now owned by Procter & Gamble), GEICO (now fully owned by Berkshire Hathaway), The Washington Post Co., and Wells Fargo were five of Berkshire Hathaway’s seven largest holdings. Buffett has seen fit to continue owning a significant stake in all of these companies.

Of course, it all seems too simple right? With all of the thick books and countless hours of TV coverage of experts opining on the ins and outs of investing, could it be that patience is really the missing ingredient for most investors?

This article, written by Matt Koppenheffer, was originally published on Bruce Jackson, who has an interest in BHP Billiton, Woolworths, Berkshire Hathaway and Wells Fargo, has updated it. The Motley Fool’s disclosure policy is no secret.

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