TOP 10 REASONS TO INVEST USING INDEX FUNDS
FUNDS GET HIGHER RETURNS
investors consistently earn above average returns on their money. This sounds counter-intuitive because, of course, index
funds track the market averages. But when you take into account all of the costs associated with actively
managed investments, it makes complete sense. And the data supports this conclusion. For
example, a recent analysis of actively managed US stock funds calculated an average annual return of 7.5% for the 20 years
ended in December 2008. During this same period, the S&P 500 index had an average annual return of
8.4%, almost a full 1% better than the active mutual funds. The difference would be even greater if we
excluded small cap stocks and adjusted for the impact of capital gains taxes. The bottom
line is that index investing is the only sure way to earn above average returns on your portfolio.
ACTIVE FUNDS ARE LOSERS (SORRY)
It may sound harsh,
but academic studies have demonstrated again and again that most active funds earn below market returns and lose to index
funds over the long run. For example, one study determined that over rolling 10 year periods, 75% of actively
managed mutual funds underperformed the market. Other studies which adjust for sales charges, risk,
and survivorship bias (i.e. by including funds which fail or merge with other funds) demonstrate even more dramatic results,
with 90 – 95% of actively managed mutual funds losing to the market index.
REST ARE JUST LUCKY (UNFORTUNATELY)
It is very tempting
to look for the few active managers with the knowledge and skill needed to consistently outperform the market.
Unfortunately, it is nearly impossible to identify the winning managers in advance because there is no persistence
among successful active managers. Studies have found that active managers who outperform the market in
one year are just as likely to underperform the market in the following year. As luck would have it, the
year to year results are random and unpredictable, like the odds of flipping a coin and getting two or more heads in a row.
With active investors, luck seems to be a more important factor than knowledge and skill.
FUNDS HAVE LOWER COSTS
The cost of active
management can be significant. For active mutual funds, they can include sales charges (loads) of up to
5%, or 1% per year for an investment held 5 years. Management fees and operating expenses for active funds
add another 1% over the cost of a comparable index fund. Hidden transaction and trading costs which directly
reduce the performance of active investments, including brokerage fees, bid-ask spreads, and market impact costs, can add
another 1% per year for portfolios with 100% turnover (which is typical). The bottom
line is that active management will cost investors an extra 2% or more per year as compared to a simple index strategy.
Even the best active managers can’t overcome the persistent weight of these higher costs.
INDEX FUNDS ARE TAX EFFICIENT
tax impact of active management is a major disadvantage for assets held in a taxable account. Active managers
tend to have high turnover rates which generate capital gains and the related tax liabilities. Even
worse, frequent trading can generate short term capital gains which are taxed at higher rates. Index mutual
funds and ETFs (exchange traded funds) are more tax efficient, with turnover of less than 10% per year. The
result is less capital gains and lower taxes. Investors can defer the bulk of their capital gain taxes
until they decide to sell the original investment. And tax deferral is almost always a good thing, especially
when compounded over many years.
INDEX FUNDS ARE WELL DIVERSIFIED
Financial theory and market studies have clearly demonstrated the benefits of
diversification in the form of higher returns and/or lower risk. As such, investors should broadly diversify
their holdings across companies, industries, countries, and asset classes. Using this approach, investors
earn risk-appropriate returns on their invested capital, and participate in the growth of the global economy, while minimizing
company, industry, and country specific risk. Index funds provide well diversified portfolios across a
wide range of asset classes at low cost to the investor. Unfortunately, most active managers make bets
(i.e. speculate) on specific companies, industries, countries, etc. exposing the portfolio to unnecessary risk.
Ironically, those who do diversify their investments begin to look and act more like index funds, but with much higher
FUNDS ARE MORE STRATEGIC
and investors spend most of their time and energy researching, analyzing and selecting specific investments to buy or sell
as part of their portfolio (e.g. individual company stocks). However, research has demonstrated that
80–100% of the long term risk and return of a well diversified portfolio is a function of the allocation across major
asset classes (e.g. Treasury bonds, large cap stocks, small cap stocks, international stocks, etc.). As
such, investors and managers should focus their investment decisions on the strategic asset allocation, not tactical asset
selection. Index funds, which provide low cost, diversified access to a wide range of asset classes, are
most appropriate for this strategic approach to managing a portfolio.
FUNDS USE HONEST BENCHMARKS
measure and evaluate the performance of their portfolio on a regular basis. The most accurate way to measure
performance is to calculate the internal rate of return (IRR) on the portfolio, taking into account the cash contributions
and withdrawals during the period. And the best way to evaluate the performance of an investment is to
use a risk-adjusted benchmark, taking into account the asset class of the investment. The S&P 500 is
a simple benchmark, but not always an apples-to-apples comparison. For example, small cap stocks should be measured against
a small cap benchmark and emerging market stocks should be measured against an emerging market benchmark. Some
active managers even mix asset classes in one fund, making it more difficult to evaluate their performance. On
the other hand, most index funds can be evaluated against a simple, standard and relevant benchmark.
INDEX FUNDS ARE LESS COMPLICATED
Managing an investment portfolio can be a complex and emotional experience for most people.
Unfortunately, too many brokerage firms and investment advisors make the experience even more complicated by accumulating
a long list of specific and sometimes overlapping stocks, bonds, mutual funds, hybrid securities (e.g. convertible bonds),
and alternative investments (e.g. hedge funds), across multiple investment accounts. The resulting portfolio
is almost impossible to understand, analyze, measure and evaluate over time. Instead, using a small
set of low cost index funds, investors can build, manage, measure and evaluate a relatively simple and straightforward portfolio
based on a clearly defined asset allocation strategy. Sometimes less is more…
INDEX FUNDS HAVE LOYAL FANS
Active management has a lot
of vocal fans because it represents a multi-billion dollar business for brokerage firms, money managers, mutual funds, hedge
funds, etc. But index investors have the strong support of the best minds in academia and beyond.
It all began with Burton Malkiel, Professor of Economics at Princeton, who wrote A Random Walk Down Wall Street.
Paul Samuelson, Nobel laureate in economics, has said “The creation of the first index fund…
was the equivalent of the invention of the wheel and the alphabet.” Jack Meyer, former president
of the Harvard Endowment, was quoted as saying “The investment business is a giant scam. Investors
should simply have index funds to keep their fees low and their taxes down.” David Swenson, chief
investment officer of the Yale Endowment, provides the following advice, “Invest in low-turnover, passively managed
index funds…” Even Warren Buffet, renowned value investor, recently bet $1 million that a
simple S&P 500 index fund will outperform a collection of hedge funds over the next 10 years.
Download Top 10 List in pdf format