Are Retail S&P 500 Index Funds a Financial Commodity? Insights for Investors

Abstract We examine whether retail SP G18 Keywords: Mutual funds; Retail index funds; Expense ratios; Portfolio performance measurement 1. Introduction Mutual funds have become the investment vehicle of choice for many investors. According to the Investment Company Institute (2005), 92 million individuals in 54 million U.S. households owned mutual funds in 2004. Investors face a complex array of choices among thousands of mutual funds with different objectives, risk, and performance. Notwithstanding the growth of index mutual funds, actively managed mutual funds dominate both the number of funds and dollar value of assets. A long-standing debate exists about whether a fund's performance is because of the quality of management, other fund attributes, or just luck. Some evidence suggests that managers of actively managed funds have some stock-picking talent (Grinblatt & Titman, 1989, 1993; Grinblatt, Titman & Wermers, 1995; Daniel, Grinblatt, Titman & Wermers, 1997; Frank, Poterba, Shackelford & Shoven, 2004). These studies base their analyses on the gross returns of the portfolio holdings of mutual funds and typically do not account for transaction costs or expenses. In his analysis of the performance of U.S. equity mutual funds from 1975 to 1994, Wermers (2000) finds that mutual fund managers hold stocks that beat the market portfolio by almost enough to cover their expenses and transactions costs. The bulk of the evidence, however, suggests that actively managed funds, on average, underperform benchmark portfolios with equivalent risk by a statistically and economically significant margin (Jensen, 1968; Malkiel, 1995; Gruber, 1996; Carhart, 1997). That is, after accounting for expenses and transactions costs, active managers typically destroy value. An implication of the underperformance of most actively managed funds is that investors would be better off in low-cost passively managed index funds. Investors often assume that trying to beat the market average over the long run is futile. They also assume that investments in index funds would at least match some index such as the Standard and Poor's (S&P) 500. Given the availability of sufficient index funds to span most investors' risk choices, these relatively low cost, passively managed index funds provide an alternative to actively managed funds. The presumed commodity-like nature of index funds suggests that price competition should be more evident than with actively managed funds. Fund managers operate index funds not to beat their benchmarks or actively managed funds, but to mimic benchmark portfolios and performance, less expenses. Therefore, fund expenses should be singularly important in explaining and predicting differences in index fund performance. With active price competition, there should be only nominal size-adjusted differences in index fund expenses for the same benchmarks. Elton, Gruber and Busse (2004) identify S&P 500 Index funds as among the simplest of financial vehicles. Yet, the returns and expenses of these financial commodities with virtually the same portfolios differ significantly. Moreover, in contrast to actively managed funds, the important performance characteristics of index funds are highly predictable. …