Free Beating the Street by Peter Lynch Page B

fact that so many funds with investments in the stocks that make up the averages can manage to do worse than the averages is a modern paradox. It seems illogical that a majority of fund managers cannot achieve an average result, but that’s the way it’s been—1990 was the eighth year in a row in which this widespread failure to match the gains recorded by the popular S&P 500 index occurred.
    The causes of this strange phenomenon are not entirely known. One theory is that fund managers are generally lousy stockpickers and would do better to scrap their computers and throw darts at the business page. Another is that the herd instinct on Wall Street has produced so many camp followers that fund managers only pretend to pursue excellence, when actually they are closet indexers whose goal in life is to match the market averages. Tragically, their residual creativity gets in their way, so they cannot do even a decent bad job, as also occurs with brilliant writers who try and fail to produce simpleminded best-sellers.
    A third and more charitable theory is that the stocks that make up the averages—especially the S&P 500 index—tend to represent large companies that in recent years have enjoyed a great run. It was harder to beat the market in the 1980s than it was in the 1970s. In the 1980s, you had massive buyouts of companies that were includedin the S&P indexes, which caused the prices of the stocks in the indexes to go up. You had a lot of foreigners investing in our market, and these foreigners preferred to buy large-company stocks with famous names. This added to the upward momentum.
    In the 1970s, on the other hand, many of these popular brand-name stocks (Polaroid, Avon Products, Xerox, the steels, the automakers) faltered because the companies themselves were doing badly. Quality growth companies such as Merck continued to thrive, but their stocks went nowhere because they were overpriced. A fund manager who avoided these big stocks had a huge advantage back then.
    A fourth theory is that the popularity of index funds has created a self-fulfilling prophecy. As more big institutions invest in indexes, more money is poured into index stocks, causing them to rise in price, which results in index funds outperforming the competition.
    So should you forget about picking a managed fund from among the hundreds on the market, invest in an index fund or a couple of index funds, and be done with it? I discussed this option with Michael Lipper, the number-one authority on mutual funds. He provided Table 3-3 . It compares the record of a large group of managed funds, here called the General Equity Funds, with the S&P 500 Reinvested, which is essentally the same thing as an index fund, minus the very small fees charged by index-fund operators.
    Lipper’s chart illustrates what we’ve already said, that throughout the recent decade the index funds beat the managed funds, and often by a wide margin. If you had put $100,000 in the Vanguard 500 index fund on January 1, 1983, and had forgotten about it, you would have celebrated January 1, 1991, with $308,450 in your pocket, but you’d have had only $236,367 in your pocket if you had put the money in the average managed equity fund. The eight-year winning streak for the indexes was finally broken in 1991.
    Over 30 years, the managed funds and the indexes are running neck and neck, with the managed funds having the slightest edge. All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage. Unless you were fortunate enough to pick one of the few funds that consistently beat the averages (more on this later), your research came to naught. There’s something to be said for the dart-board method of investing: buy the whole dart board.
    Table 3-3. MUTUAL FUND MANAGERS VERSUS S&P 500®
    The S&P 500 Index has outperformed the average mutual fund manager in 8 of the past 10 years