This is Part 2 of a two-part post on index funds and why I think they are superior investment vehicles for investing in stocks and bonds. If you haven’t read Part 1, please read that post first.
In Part 1, I discussed how index fund investing works and provided eight reasons why I think index fund investing makes sense for most people. Part 2 discusses seven additional reasons why index fund investing makes sense.
The Case for Index Fund Investing — Continued
9. The Challenge of Picking Actively Managed Funds — Style Drift
Another problem with chasing the past performance of an actively managed fund is that its underlying investing strategy can change. This is referred to as style drift.
Below is a graph from Investment Fund Advisors showing the relative stability of the S&P 500 from 1982 – 2017 in terms of its composition of roughly equal parts large-cap growth and large-cap value stocks.
Contrast that with the Vanguard Explorer Fund, which from being a small-cap value stock fund to a small-cap growth stock fund.
Style drift can happen for many different reasons, including a change in managers, a change in investment thesis, a desire to make a new type of bet, market timing or being forced to change.
Whatever the reason for the change, style drift can have real consequences, including the fund earning very different types of returns based on exposure to new risks and changes in the types of bets being made by the fund.
In addition, style drift can make it very difficult for the investor to understand and properly manage one’s asset allocation. Investors looking for exposure to small-cap value stocks and who invested in the Vanguard Explorer fund in 1991 would find themselves just two years later invested in a fund that has turned into a growth stock fund.
Even if a fund doesn’t deliberately seek to make changes to its underlying investment style, it may find itself unable to maintain its performance or execute its investment thesis.
Victims of Their Own Success
When a fund does well, it attracts a lot of new investment dollars from investors looking to chase that past performance. Once the inflow of investment dollars goes into the fund, the fund gets larger. As the fund gets larger, the fund manager gets richer since its fees are equal to a percentage of the amount invested.
However, all those new funds can impact the performance of the fund, particularly an actively managed fund. It can be much harder for the actively fund to execute on the strategy that made the fund successful in the first place.
Instead of finding one hidden gem that can generate out-sized returns, the actively managed fund now has to start making and winning multiple bets in order to move the needle on a much larger asset base. It’s always a lot easier to come up with 1 great idea than 10.
And, for funds that focus on a particular niche, like small-cap companies, it may become difficult for a fund with a large, growing asset base to deploy those funds without negatively impacting their returns. Buying shares drives up stock prices, and this can be especially pronounced in stocks with small market caps and floats. If the fund’s purchasing results in a big supply and demand imbalance for those shares, the fund may not even be able to purchase the position it wants in the small-cap company before it begins driving up the company’s stock price.
10. Everyone’s Doing It. Index fund investing has gained a lot of momentum over the last decade as more and more people become familiar with the data on index funds vs. actively managed funds.
According to the Associated Press, in 2018, investors poured a net $206.5 billion into US stock index funds and pulled $174.1 billion out of actively managed ones. U.S. stock index funds and ETFs now control $3.6T of assets, close to the $3.77T in actively managed funds. That’s extraordinary growth when you consider that the first index fund wasn’t available until 1976 and didn’t hit $100B in assets until 1999.
11. Warren Buffett Strongly Recommends Index Funds. Warren Buffett, one of the world’s greatest investors and wealthiest persons, said this about index funds:
I think it’s the thing that makes the most sense practically all the time.
In fact, Buffett has publicly said that in his will he offers the following instructions to his wife: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund (I suggest Vanguard’s).”
And, Buffett walks the walk. In 2007, Buffett made a $1 million bet with a hedge fund, Protege Partners, that actively-managed hedge funds with the most sophisticated strategies and resources wouldn’t be able to beat the performance of the S&P 500 over a 10-year period. Surely, hedge funds run by the smartest financial minds with access to the best technology and information would beat the humble index fund accessible to the unwashed masses.
It turns out that the S&P 500 easily trounced a basket of 5 hedge funds selected by Protege. Over a 10-year period from 2008-2017, the S&P 500 returned 125% vs. 36% for the hedge funds. Somehow, the simple, modest index fund destroyed the pickings of elite Wall Street experts.
12. Taxes. Outside of investing in tax-deferred and tax-free accounts like a 401(k) and other retirement accounts, investing incurs taxes. Stocks and bonds can realize capital gains. Also, stocks can issue dividends, and bonds throw off interest.
Active trading in individual stocks or investing in an actively managed mutual fund is, by definition, more active than index fund investing. Fund managers are frequently buying and selling stocks to try and out-perform the market. However, there’s a real tax drag to this activity. Frequent trading creates a much greater chance that you will incur higher-taxed short-term capital gains instead of lower-taxed long-term capital gains.
The beauty of well-constructed index funds, and particularly market-weighted index funds, is that there is usually much less in taxes generated due to the relatively infrequent trading by the fund.
In fact, Burton Malkiel and Charles Ellis in The Elements of Investing calculated that in order “to overcome the drag of expenses and taxes, an actively managed fund would have to outperform the market by 4.3% per year just to break even with index funds.“
If you must invest in an actively managed fund, find one with a low expense ratio and low turnover and low unrealized losses.
13. Understanding the Returns on Your Actively Managed Fund and Comparing to the Proper Benchmark.
Let’s say you invest in actively managed funds or that you actively trade your own investments. Do you know or calculate your returns? It’s not good enough just to know that you’ve been making money. Pretty much anyone who has invested in stocks and bonds over the past decade has made money, but did you earn your fair share of returns or take uncompensated risk?
Let’s say that your actively managed investments have been generating returns that have consistently beaten “the market.” That’s great, but the next thing to do is to make sure that you are comparing your returns to the appropriate index. This will help you better assess whether the out-performance was true out-performance or whether it had to do with taking on additional risk.
Maybe your beat the S&P 500 by 1% each year but you did so with a portfolio of small cap stocks. You took a lot of incremental risk because stock Beta risk to get that additional 1%.
If your actively managed investments were primarily in small companies, or technology companies, compare your returns to the Russell 2000 or the Nasdaq 100, respectively. If you’re making bets based on a particular sector but aren’t beating that sector, you might find that you could more efficiently and cheaply buy index funds covering that sector instead.
And, data from S&P confirms that once adjusted for size and style risk, most funds underperform their appropriate benchmarks:
- When you look at the data and break down funds by size (large, mid and small) and style (growth, value and core), the vast, vast majority of funds underperform their respective benchmarks when looking at the past 3, 5, 10 and 15 years.
- For most categories of US stock funds, 90% to 95% of funds underperform their benchmarks. The one outlier is U.S. large-cap value funds where only 80% of funds have underperformed its benchmark index over the past 15 years.
14. Investing in Individual Stocks. OK, so if, on average, actively managed mutual funds are more expensive and don’t perform as well as index funds, why not just cut out the middleman and pick individual stocks then?
Technology has made trading in individual stocks really easy, and buying and selling individual stocks can be a fun and exciting thing to do.
However, doing it well and beating the market is really, really hard. The data shows that individuals who pick stocks are bad at it.
Terrance Odean, a professor of finance at UC Berkeley, analyzed the trading activity of over 60,000 households with discount brokerage accounts and found that:
- Individuals underperformed value weighted market indices
- On average, the stocks that the investors bought underperformed the stocks they sold
- Individuals who trade in stocks trade a lot and incur significant costs as a result of their frequent activity
Managers of actively managed mutual funds spend all their working hours focused on crafting the perfect portfolio. As a lawyer or other professional, you spend most of your working hours lawyering or developing your professional career.
Fund managers have significant resources to research and evaluate stocks. You have Yahoo Finance, CNBC and stock tips from your neighbor and the gas station.
Fund managers likely have had educational training in finance and have strong views on fundamental analysis and maybe even the voodoo world of technical analysis. We went to law school.
I know that no matter how much time I spend researching a stock and the underlying company and its business, I’m not going to discover any insights that aren’t already known to the market already and certainly not anything that institutional investors don’t already know. And, unlike institutions, I don’t have access to the CEO or CFO of the companies that I might invest in. I’m pretty certain that I don’t find out about insights or great tips until millions of others have already found that out.
When you’re trading individual stocks, you’re making a bet, and in all likelihood, the person on the other side of your trade is a big, sophisticated institution. Institutional trading is what drives the vast majority of trading volume on a day-to-day basis. Increasingly, the person on the other side of your trade isn’t even a person – it’s a computer that based on algorithms has determined that it can extract value by trading with you.
The reality is that, as amateurs, trying to pick individual stocks and out-perform professional money managers is like taking a knife to a gunfight except you think it’s going to be a fistfight. And, you’re also blindfolded. You might get lucky, but the odds are stacked against you.
Sure, it may be fun and thrilling to trade individual stocks. There’s instant gratification and feedback in being able to check stock prices every day, hour or minute. However, just because it’s fun / exciting / entertaining to trade individual stock doesn’t mean you’re good at it.
And, let me throw in another pithy Warren Buffett quote from a February 2019 appearance on CNBC:
Most people don’t know how to pick stocks. And – most of the time, I don’t know how to pick stocks.
If you still can’t resist the urge, I recommend setting aside some play money, money that you can afford to lose, to do your individual trading. But, if you’re going to trade individual stocks, be honest with yourself also. Track your performance so that you know how you actually do.
Beyond the likelihood of underperformance, buying individual stocks raises another problem: lack of diversification. [Index funds easily solve this problem].
15. Potential Downsides to Index Funds. So, is investing in index funds all lollipops, rainbows and unicorns without any negatives? For the most part, Yes. However, if you invest in index funds, there are still a few things to be aware of:
- Investing in index funds isn’t risk-free. Whether you are investing in a stock or bond index fund, you will still be subject to the risk of the underlying basket of securities.
- You are not going to get jackpot-like returns like when an individual stock hits it big and returns 15x over a few years.
- Not every index fund, and every provider of index funds, is the same. Some are constructed better than others. For example, Ryder offers an S&P 500 index fund with a 2.33% expense ratio. You’d be crazy to put your money in that fund when you can pay just 0.04% for Vanguard’s S&P 500 index fund. In a May 6, 2019 article, the WSJ reports that more than $121 billion is invested in index funds with expense ratios greater than 0.5%.
- It’s not as exciting to talk with friends and family about index fund investing as individual stocks (unless your friends and family are fellow investment nerds who love to talk about asset allocations, expense ratios and Fama-French factors).
- It is guaranteed that every year there will be individual securities and funds that outperform the benchmark index and corresponding index funds. You will have to be comfortable with doing really, really well rather than the absolute best.
Conclusion
So, there you have it. 5,000+ words on why I invest in index funds and why I think you should too (thank you for reading if you got this far). Please let me know what you think – send me an email or leave a comment below.
