By George Sisti
Published: Feb 29, 2016 12:57 p.m. ET
According to Vanguard, only about 16% of the $13 trillion in domestic mutual funds is invested in index funds. The benefits of index investing are arithmetic reality and incontrovertible. I long for the day when this is obvious to all investors. Until then, like a voice crying in the wilderness, I’ll continue to proclaim these 10 reasons why I’m a proponent of index investing.
1. There is no reliable method of finding skilled fund managers. Short-term performance cannot be used to do so. Some studies I’ve read indicate it may take 20 years to mathematically separate manager skill from luck. Finding a fund that will outperform its benchmark index over the next 15 years is like trying to find the proverbial needle in the haystack.
2. According to Standard & Poor’s, in the 10 years ending June 30, 2015, 75% of actively managed domestic stock funds underperformed the S&P 1500 Total Market Index. Additionally, 40% of actively managed equity funds available to investors on June 30, 2005, were no longer in existence 10 years later. So how can actively managed mutual funds be considered good stewards of shareholder money?
3. The turnover ratio of the average actively managed domestic stock fund exceeds 100%. This means that the average fund manager holds a stock for less than one year in a vain attempt to «beat the market,» outperform competitors and attract new investors to the fund. But frequent trading has its costs — assume a 1% increase in annual costs for a 100% turnover ratio. I’m a long-term investor, yet many fund managers are short-term traders. There’s a big disconnect here.
4. Most actively managed funds underperform their benchmark index after costs are deducted. This has nothing to do with investing and everything to do with arithmetic:
- Index funds, by design, will earn the stock market’s return before costs are deducted.
- Actively managed funds, as a group, will also earn the stock market’s return before costs are deducted.
- All index funds and the average actively managed mutual fund will underperform the market by the amount of their expenses.
- Since index funds have lower expenses than actively managed funds, they will outperform the average actively managed fund in their asset class, net of costs. This will be true for all asset classes and all time periods.
5. I desire is to capture, as efficiently as possible, the growth of the global economy. The most cost-effective way to do this is to own a globally diversified portfolio of index funds.
6. Life is too short to become a stock-market addict. Watching the market every day will drive you crazy and won’t increase your chances of outperforming market averages. If the pros can’t do it, you don’t have a prayer. In fact, the more you trade, the higher costs you’ll incur, and the lower your returns will be. If that’s your idea of a good time, have a nice day.
7. I like to know the precise asset allocation of my portfolio. Active managers have too much flexibility to chase returns and invest in assets that are not contained in their stated benchmark index. This «style drift» makes it difficult for fund shareholders to know exactly where their money is invested.
8. Mutual-fund companies offer to sell you last year’s winners when they advertise funds with recent good performance. Past performance is an easy sell, but suffering from reversion to the mean isn’t any fun. Chasing past performance will wear you out emotionally and devastate you financially.
9. The most often-cited reason that most actively manage funds underperform index funds is their higher expenses. There’s another significant component to this underperformance. The best-performing stocks in a market index will have much higher returns than most stocks in the index. The index’s annual return depends heavily on these few stocks. Active managers must own a limited number of stocks from the index they seek to outperform. Since the best performers are few in number, it’s more likely that managers will select underperformers, not the few big winners. The probability that a fund will underperform is inversely proportional to the number of stocks in its portfolio.
10. The benefits of index investing are apparent to Warren Buffett who gave this advice in his 1997 letter to shareholders: «The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of professionals.»
If there ever comes the day when we define investment failure as earning less than what the stock market freely offers, there will be no excuse for not owning index funds. Until then, clients of financial advisors who promote actively managed mutual funds will likely underperform a passive investment strategy that their advisors so often mock.