How does an index fund achieve an excess return of 160 basis points?
The Nov. 11 special mutual fund report contained Frank Sortino's style-adjusted analysis of mutual funds. It showed the Vanguard Index 500 fund producing a 160-basis-point overperformance.
I ran a style analysis, using StyleAdvisor, on the Vanguard Index 500 mutual fund using four sets of style indexes to find the combination of style indexes that most closely tracks this fund.
For instance, using four Russell style indexes, the combination that most closely tracks the Vanguard Index 500 fund is 49.9% large growth and 49.1% large value and 1% T-bills. A benchmark made up of those style indexes would have a 98.77% R2 to the Vanguard Index 500 fund.
My style analysis shows the annualized excess return over the style benchmark. In this case, for the Russell style indexes, it is -0.33%.
Using the BZW style indexes or the S&P BARRA Growth and Value indexes, the annualized excess return is -0.12%.
For the Prudential style indexes it is
-0.51%.
For Wilshire's style indexes it is -0.11%.
Notice that these were all run during the same five years as Frank Sortino did in his analysis.
How did he get an excess return over his style benchmark of 1.6% annually?
Keep in mind the excess return over the style benchmark is designed to measure a manager's skill. I think we will all agree it doesn't require any skill to build an index fund.
Therefore, there should be no excess return. If anything, there should be a slightly negative return because of the fees charged by the index fund; that is what my style analysis is showing.
I suspect Mr. Sortino is getting this rather strange value because of the style indexes he is using (those of Dimensional Fund Advisors, to which I obtaining access), or because of his system of adjusting for downside risk.Whatever the case, I would not want to be in the position of having to explain how come an index fund has such a high annualized excess return.
Steve Hardy is principal of Zephyr Associates Inc., Zephyr Cove, Nev.
