When it comes to investing in stocks and bonds, most of my investments are held in index funds. It would be “all” instead of “most,” except the younger version of the Money Blawgger used to gamble invest in individual stocks that the older Money Blawgger is now stuck with because selling would generate unwanted taxes.
For me, and I think for the vast majority of investors, stock and bonds should form the core of any investment portfolio, and index funds should be the vehicle for making those investments. It’s something I feel pretty strongly about – enough so that I wrote a 5,000+ word post on the topic. To make things easier for the reader, I’ve split the post into two parts. Here is Part 1.
What is Indexing?
Indexing is an investment strategy that allows the investor to earn the investment returns of a particular benchmark index (e.g. S&P 500) through a mutual fund or exchange-traded fund (ETF).
Often referred to as passive investing, index fund investing doesn’t seek to pick the best stocks, hidden gems or any specific securities. Rather, the way it works is that the index fund provider (e.g. Vanguard, BlackRock, State Street) creates an investment vehicle (mutual fund or ETF) that holds assets mirroring a particular index. The investor then purchases shares of the mutual fund or ETF.
Below is a table showing some popular indices, along with some mutual funds and ETFs tracking those indices:
Many of the indices tracked by the largest and most popular stock index funds are capitalization-weighted, which means that the components of the index are held according to their relative market capitalization.
For example, the Wilshire 5000 is a capitalization-weighted index of all US public company stocks. At the end of April 2019, Microsoft had a market capitalization of $1 trillion while Ford had a market cap of $40 billion. A capitalization-weighted total US stock market index like the Wilshire 5000 would hold shares of both Microsoft and Ford in their relative weights, so in the index, the value of the Microsoft shares are 25x the value of Ford shares.
The Case for Index Fund Investing
So, why do I think index funds are the right investment vehicle for me and 99.9% of my readers? It’s extremely powerful and effective. Don’t be fooled by the wimpy-sounding name “passive” investing. After expenses and taxes, index fund investing allows you to capture superior returns with very little, if any, effort on your part.
1. The Total Package. The Bogleheads Guide to Investing sums up the power of index fund investing very well:
It takes very little investment knowledge, no skill practically, no time or effort – and outperforms about 80 percent of all investors.
Let’s unpack this a little bit.
2. Exposure to the Market. Investing through index funds is the easiest way to own an entire market. With just one fund, such as Vanguard’s total US stock market index fund, you can own all U.S. publicly-traded stocks. This allows an investor to participate in the growth of the U.S. economy at a very broad level with just one investment. With just another fund, such as Vanguard’s total US bond market index fund, you can own the thousands of investment-grade bonds issued by the US government and corporations making up the Bloomberg Barclays US Aggregate Bond Index.
3. Diversification. Buying an index fund provides instant diversification. By owning a total stock market index fund, I don’t have to worry about, or follow, any one particular company’s performance. If I purchase shares of a total stock market index fund, my risk is spread over 3,500 stocks. I don’t have to worry about the impact of Elon Musk’s tweets on Twitter’s stock price or whether a CEO of a particular company is cooking the books. If Tesla goes up, great, because I own shares through the index fund. If Tesla stock tanks, no big deal, my loss is spread over 3,500 stocks.
Similarly, if I purchase shares of a total bond market index fund, my risk is spread over 8,000 different bonds. I don’t have to worry about any one particular company being unable to make its payment obligations.
4. Time and Effort. Investing in index funds allow me to set things and forget about them — I get to sit back and earn whatever the market delivers. While I enjoy learning about investing, I really don’t want to spend more time on that than I need to. In particular, I have no interest in researching and tracking individual companies, following their latest products and market trends, and reviewing their financial statements (and the footnotes to those financials, where all the good stuff is hidden). I’d rather spend time with my family, writing articles for you fine folks to read, sitting on the couch watching TV or just about anything else.
4. Super Low Costs. Cost matters, and matters a lot, when it comes to investing.
When you look just at cost and nothing else, cheaper funds outperform more expensive funds:
The good news is that your investment costs are one of the few things that you can control.
Great index funds are accessible to retail investors like you and me at very low cost. For example, the expense ratio for Vanguard’s total stock market index fund is just 0.04%. This means that for every $10K you invest in that fund, Vanguard takes just $4 per year as fees. Some index fund providers even now offer index funds with a zero expense ratio – investing in stocks is basically free!
Contrast that to costs of actively managed mutual funds, where portfolio managers pick individual stocks with the goal of beating the market.
According to a study of 25,000 open-end mutual funds conducted by Morningstar, the average annual expense ratio for actively managed mutual funds in 2018 was just under 0.75%.
Let’s say you have an actively managed mutual fund and a passive index fund that both return 7% per year, but their expenses ratios are 0.75% and 0.04%, respectively. If you invest $500K into each fund, after 20 years, the value of your index fund is worth $240K more than the actively managed fund, with the difference all due to the difference in expense ratios.
In the case of the actively managed mutual fund with the 0.75% expense ratio, the aggregate costs paid to the fund were equal to 22% of the aggregate amount earned by the fund, while for the index fund, fees represented only 1% of the fund’s earnings.
Every additional amount charged by an investment manager means that much less in your pocket.
John Bogle in Enough aptly summarized the impact of costs charged by mutual fund managers and who they benefit:
Today, if fund managers can claim to be wizards at anything, it is in extracting money from investors. In 2007, the direct costs of the mutual fund system totaled more than $100 billion year after year paid by the investors themselves.
5. Superior Performance of Index Funds. On average, index fund investors earn returns that beat returns from actively managed funds. The evidence and data are overwhelming. It’s not even close.
Here is just some of the data:
- S&P Dow Jones keeps a scorecard of mutual fund performance (the SPIVA Scorecard) and found that over the past 15 years, 89% of all U.S. stock funds, 90% of all international funds and 91% of all intermediate-term government bond funds underperformed their respective benchmark indices.
- Vanguard, using data from Morningstar, calculated that in the past 15 years, only 35% of actively managed stock funds and 27% of actively managed bond funds beat their respective benchmarks.
- Jeremy Siegel in Stocks for the Long Run, found that in the 40 years between 1972 and 2012, a majority of mutual funds beat the Wilshire 5000 index only 12 times – all but two of the funds involved small cap funds.
- John Bogle calculated that from 1980 to 2005, the Vanguard index fund tracking the S&P 500 earned an average return of 12.3% while the average actively managed U.S. stock fund earned just 10%.
- Money Magazine reports that in 2018, only 1/3 of actively managed U.S. stock funds outperformed their benchmarks. 2018 was the ninth consecutive year where large-cap funds underperformed the S&P 500.
An Explanation for the Out-Performance
By definition, the aggregate of all investors make up the market and collectively earn the market return. An index fund investor earns the market return, less the fees paid to the index fund provider. While this might seem like the index investor is only earning an “average” or 50th percentile return, index fund investors actually do far better than that compared to other investors (as seen by the above data). Why is that?
While the data shows that many actively managed funds don’t beat market returns, some do. However, after taking into account the fees charged by actively managed funds, many investors in those out-performing actively managed funds end up earning less than the index fund investor.
It’s a losing proposition for an investor in the actively managed fund that earns 11% to the the market return of 10% if the active fund charges the investor 2% to get that 11% return. There’s the rub. Once you take into account costs and expenses, most active investors earn less and can’t even match market returns.
6. The Superior Performance of Index Fund is Actually Understated. Poor performing actively managed mutual funds go out of business — investors withdraw funds, they get shut down, merged out of existence or management teams/styles change (e.g. value stock picking didn’t work, so the fund rebrands as a growth stock fund).
- S&P calculates that as of December 31, 2018, over a 15-year period, 57% of all US equity funds, 49% of international equity funds and 52% of all bond funds were either merged or liquidated.
- According to John Bogle in Enough, published in 2008, nearly 2,800 of 6,126 mutual funds that existed are already dead and gone. If these “dead funds” were included in the comparisons, index fund out-performance would look even better.
7. The Challenge of Picking Actively Managed Funds – Past Performance. Maybe you’re thinking that my earlier example comparing the costs of an index fund and actively managed fund both earning 7% wasn’t a fair comparison. After all, no one in their right mind is going to invest their money in the more expensive actively managed fund if its returns are only going to equal (or under-perform) the index fund. The solution is to pick a fund that’s going to beat the market. Easy, right?
Unfortunately, it’s very, very hard. So hard that you and I have little ability to figure out in advance which fund will perform the best.
One way to try and pick the best actively managed fund is to look at the past performance of different funds. Whichever fund earned the highest return in the past should be most likely do well in the future, right? There must have been some magic sauce that caused those best funds to out-perform.
The data say otherwise:
- S&P, in their Persistence Scorecard, found that of all US stock funds that were top quartile performers as of September 2014, by September 2018, only 1.43% of those top-performing funds were still remaining in the top quartile.
- According to the Bogleheads Guide on Investing, since the 1960s, the average return of the 20 top-performing funds in each decade subsequently under-performed the market in the next decade.
- In the Elements of Investing, Burton Malkiel and Charles Ellis report that for the 9-year period ending on December 31, 2007, only 14 stock mutual funds out-performed the S&P 500 9 years in a row. However, in 2008, 13 of those 14 funds under-performed the S&P 500.
8. The Challenge of Picking Actively Managed Funds — Going With a Superstar Investment Manager
Maybe you think the way to pick the best actively managed fund to beat the market is to pick the right investment fund manager. Sorry, but this is just another variant of looking at the past performance of actively managed funds. Just because a specific fund manager performed well in the past does not mean that the active fund manager will perform well in the future.
There are skilled investment managers who can and do beat the market, but it’s almost a certainty that you won’t know who they are in advance.
One practical problem is that unless the investment manager already has a successful track record and is well known, you are unlikely to even know about their existence given the thousands of funds out there, let alone, being willing to invest your hard-earned money with an unknown. That’s like hiring a new law school graduate to defend you in a murder case on the hopes that the graduate has Johnny Cochran’s talent.
But, what about the superstar fund managers who are famous for their past performance and get regularly featured on CNBC or in the financial press?
The problem is that they don’t always continue out-performing. In some cases, they fail and fail spectacularly.
One of the most famous is Bill Miller, formerly of Legg Mason, who outperformed the market for two decades. However, in the span of just 18 months, by the end of 2008, his fund performed so poorly that the aggregate out-performance of two decades was completely wiped out. Anyone who decided to invest money with Bill Miller after seeing his 20 years of superior performance would have lost a lot of money.
Skill or Luck?
Part of the challenge with picking a manager who has out-performed the market in the past is that you don’t know whether their prior performance was due to skill or luck. Maybe you don’t care because results are results, but then you are essentially gambling.
Statistics tell us that just by random chance alone, and irrespective of skill, there should be a small group of active managers who consistently outperform the market. Take this coin-flipping example.
If 10,000 people each flip a coin 10 times, probability tells us that we are highly likely to end up with 10 people who flipped 10 heads in a row (10,000 x 0.5^10). Did the 10 people out of 10,000 who flipped 10 heads in a row have some special skill at flipping heads?
Similarly with investing, when looking at the “superstar” active fund managers who have consistently beat market returns in the past, how do you know if that prior performance was due to skill or random chance? Was Bill Miller skillful or lucky?
Finally, as discussed above in #4, you have to keep costs in mind. Skilled investment managers don’t work for free – as superstars, they are compensated well. Guess who bears that costs? Investors.
Perhaps former active management superstar and best-selling author on investments, Peter Lynch of Fidelity, said it best in Barron’s that “most individual investors would be better off in an index mutual fund.”
To Be Continued…
I hope you enjoyed the first part of a two-part post on index fund investing. Stay tuned for Part 2! In the meantime, please let me know what you think – send me an email or leave a comment below.
