The Benefits of Using Index Funds

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.” – Warren Buffet

At this point most people know the advantages that come with investing in index funds.  They are tax efficient because of their low turnover.   This lowers the transaction costs in the funds making them less expensive to manage.  The expenses are extremely low compared to actively managed funds for these reasons.  Vanguard’s equity index funds average a 0.20% expense ratio vs. 1.12% for actively managed funds.  They guarantee to give you almost exactly the market’s return less the low fees you pay.  Index funds are extremely diversified so you don’t have to worry about concentration risk of having all of your eggs in one basket.

In 2011, 84% of all actively managed mutual funds got beat by a simple S&P 500 index fund.  The long-term performance numbers of index funds are just as good.  When measured against its large cap stock universe from Morningstar mutual fund research, over the last 3, 5, 7, and 10 years through the end of 2012 the S&P 500 has outperformed 75% of all large-cap mutual funds.

That’s a huge number of active funds that a simple index fund is beating.  It’s not like half of the funds outperform and half don’t and the market gets the average in the middle.  It’s destroying active mutual funds.  So not only are you paying higher fees to active mutual funds but three-quarters of them are getting beat by their benchmark on a consistent basis.

These are the attributes that have been well documented many times over the years by proponents of index funds.  And they are right to point them out.  But one of the main differences between index funds and actively managed funds doesn’t get as much press as the other details I listed.

That is the fact that any time your financial advisor, a financial website or your 401(k) provider talks about asset allocation and dividing up your stocks and bonds into certain percentages they always use index returns for the markets that they run their historical models on.

So if you are shown a historical risk and return profile for a portfolio of 75% stocks and 25% bonds that they recommend you use for your asset mix they will most likely be using the S&P 500 Index returns (or some combination of small, mid and large-cap stock indices) for the stock portion of the portfolio and the Barclays Capital Aggregate Bond Market Index returns for the bond portion of the portfolio.

Then when they give fund recommendations to get to these target percentages they give you actively managed funds to choose from.  These funds will not give you the same return and risk characteristics that you have been presented in the historical simulation.  This is because to beat the index that they are benchmarking against, actively managed funds need to make bets that vary from the index to possibly outperform.  They do this by over or underweighting individual stocks or sectors and going into different market cap sized stocks.

Your large cap fund that your financial advisor or 401(k) provider has recommended may underweight technology stocks vs. the index or pick more mid-cap stocks if they are having trouble finding large cap names in their universe that they like.  This is called style drift and it is one of the reasons that S&P 500 Index has been in the top quartile of mutual fund performance in the past on a 3, 5, 7 and 10-year basis like I explained above.

And if the funds do have similar risk and return characteristics as the index fund then that means that they are just a closet index fund masquerading as an actively managed fund and you are paying much higher fees to a fund company to get the same returns.

It is possible to pick winning funds in the short and even intermediate term.  But if you are investing for the long haul wouldn’t you take the route that beats more than half of the competitors in the field year in and year out over the gamble of possibly outperforming?

Many people in the past few years have felt that investing in the stock market has been like going to the casino to gamble.  Well, I don’t know many games at the casino that offer you long-term odds of winning more than 75% of the time.

One more aspect of active fund management that will see changes going forward is that it will be harder for the mutual fund companies to attract talented portfolio managers that can actually beat the market.  In the past successful portfolio managers like Bill Gross, Peter Lynch, Jean-Marie Eveillard and Bruce Berkowitz have chosen to manage mutual funds that the investing public has had access to.

But with the proliferation of hedge funds in the last couple of decades the incentives to join the mutual fund industry just aren’t there anymore.  The most talented portfolio managers have been and will continue to join hedge funds where they will be more highly compensated with fewer restrictions on what they can invest in.  That will make it even harder for active mutual funds to outperform because the talent just won’t be there anymore.

Warren Buffett, David Swensen, John Bogle and many of the other great investors think that normal investors like us should invest in index funds for all of the reasons I have discussed above.  Now you have a couple more reasons.  The next time you look at your fund offerings and asset mix make sure that you understand the differences between index funds and actively managed funds.

Also, ask your advisor why they are showing you historical and possibly future expected returns for the entire market but only recommending that you invest in a portion of that market by using their active funds.  Use index funds to gain the tax efficiency, lower fees, lower transaction costs, diversification and the market return that you should be getting.  And you never have to worry about how your returns stack up against the big, bad stock market.  It will be the same.  This may sound like a boring approach but it will get you the results you need and do so using common sense investments.

If you are new to investing in index funds or ETFs, here are some of the main fund companies that carry them: Vanguard, Charles Schwab, iShares and T. Rowe Price.  Hopefully, your 401(k) provider also has index fund options.  This is not always the case since fund companies make much more money peddling active funds with higher fees.  If you can’t get access to index funds in your 401(k), contribute enough to get your company match and invest your remaining retirement contributions in an IRA account with one of the fund companies listed above to gain access to index funds.

Keep it simple and invest in index funds.  Over the long-term, you will be much better off and won’t have to worry about beating the market every year.  That’s because you’ll be earning the market return with your index funds.