Index Investing

What are index funds and ETFs? An index fund is a type of mutual fund that tries to mirror the performance of a specific index, such as the S&P 500. Index funds are passively managed, so they typically own a collection of securities representative of the target index and only trade securities when the composition of the index changes. Many index funds can be purchased commission-free through mutual fund companies like Vanguard (see Why Vanguard).

An Exchange-Traded Fund (ETF) is a security that tracks an index, commodity, or basket of goods like an index fund but trades throughout the day like a stock. ETFs that passively track market indexes are popular with index investors because of their low expense ratios and trading flexibility. ETFs are purchased on an exchange using a brokerage account.

Investors can use index funds, ETFs, or a mixture of both to pursue an indexing strategy. We believe that mutual funds are the most appropriate investment vehicle for most do-it-yourself investors, primarily because their cost structure encourages good investment practices like dollar-cost averaging and portfolio rebalancing. We list comparable ETFs in our portfolio recommendations for the benefit of investors who are comfortable with these securities and prefer them to mutual funds. To learn more about the differences between index funds and ETFs, check out George's article entitled Index Investing - Mutual Funds vs. ETFs.

What are the advantages of index investing?

Low Costs, High Returns Numerous comprehensive studies have concluded that index funds significantly outperform the vast majority of actively-managed mutual funds, especially over longer time periods. According to data compiled by the Bogle Financial Markets Research Center, two-thirds of actively-managed mutual funds fail to beat their benchmark in a typical year and over 80% fail to beat their benchmark over a typical 20-year period. So what’s the secret to the successful records of index funds? Low costs.

Simple math tells us that the average mutual fund investor earns a return equal to the market return minus any expenses incurred. An actively-managed mutual fund must endure numerous debilitating costs while attempting to beat a market index. Administrative, management, and marketing costs result in average expense ratios of 1.5%, transaction costs add another 0.85%, and the opportunity cost of holding an average of 8% cash reserves adds 0.40% (assuming a 5% equity risk premium).¹ The result: average total annual expenses of 2.75%.

Index funds don’t require highly-paid analysts or stock pickers, they minimize annual fund turnover, and they stay 100% invested in the index (no need for cash reserves). The average total annual expenses of the index funds that we recommend are less than 0.35%.

The chart below shows the devastating effect of this difference in expenses over a 50-year time horizon, assuming an initial investment of $10,000 and an annual market return of 8%. When it comes to active management, the guy who gets paid is clearly not the investor. As Fred Schwed famously asked in his 1940 book title, “Where are the Customers’ Yachts?”

¹Data from Bogle Financial Markets Research Center and Morningstar

Simplicity/Transparency Successful investors pay very close attention to asset allocation. A study by Ibbotson Associates concluded that asset allocation decisions determine about 100% of investment performance for those who follow a low-cost, long-term investing strategy. For an index investor, asset allocation is greatly simplified. A small-cap value index fund, for example, maintains a 100% investment in small-cap value stocks, so an index investor knows how much of his portfolio is invested in small-cap value stocks at all times. An investor in an actively-managed mutual fund enjoys no such simplicity. Active funds frequently exhibit style drift; they stray from their described style in the hope of increasing returns. As a result, an actively-managed "small-cap value fund" could actually consist of large-cap, growth, and/or cash holdings at any time. Style drift takes the all-important asset allocation decision out of the hands of the investor, potentially reducing portfolio diversification and increasing risk.

Discipline/Psychology An index investor who designs a risk-appropriate investment plan and sticks with it by following his Investment Policy Statement can systematically avoid many of the harmful behavioral tendencies that destroy investment returns.

What are the disadvantages of index investing?

You won’t beat the index In the above sections, we’ve tried to demonstrate that the index return is tough to beat, especially over the long term. Each year, however, there are active managers who beat the index (typically 30-40%, with about 10% sustaining their out-performance over the next two years).²Identifying these successful managers in advance is difficult to do, as is determining whether their performance was a result of luck or skill, but nevertheless, some investors can't give up this quest.

For those who know that they should invest in index funds but can’t resist the urge to be an “active” participant in the market, we’d recommend setting aside a small percentage of your portfolio (10% or less) to pursue active strategies. Keep this money separate from your risk-appropriate, strategically allocated portfolio, and decide beforehand that when the money’s gone, it’s game over.

²Data from Morningstar and Barclays Global Investors

It’s boring If excitement is your investing priority, index investing probably isn't for you. This is a get-rich-slowly methodology. Once you settle into an asset allocation plan that's consistent with your risk capacity, you simply monitor your investments and rebalance when necessary. Your compound returns, when compared to those from an actively-managed strategy, will be anything but boring!