While strong performance relative to active management has driven the growth in indexing’s popularity, there are lots of other reasons to embrace index funds as part of your portfolio. Let’s look at a few of them.
• Broad diversification – Market tracking funds by definition hold most, if not all, of the securities in their target indexes. An actively managed fund typically holds a much smaller selection of securities, typically around 150 to 250 stocks.
Holding a concentrated number of positions certainly allows for outperforming the market, though the probability is low. Many actively managed funds go in the opposite direction – they hold several hundred of stocks, in proportions similar to the benchmarks, guaranteeing performance won’t lag too much. Adding a few of these to your portfolio guarantees your returns will be index-like, prior to paying much larger fees than those of index funds.
We see this pattern time and again with prospective clients. Their portfolios consist of multiple actively-managed large cap stock funds. If you “open the hood”, they own thousands of stocks. It simply means they are closet indexers, but they mistakenly think they can outperform.
• Predictability – A thoughtful financial plan is the foundation or achieving financial goals over time. While no one has an effective crystal ball, financial plans must make assumptions about market returns and risks inherent in various asset classes – and how they perform in combination. The use of market tracking funds allows investors to be more precise in realizing the portfolio characteristics assumed by their plan.
Active fund managers can take on more or less risk than expected, underperform their benchmarks, or drift from their stated style. Their returns can then deviate significantly from those predicted by the plan. Index funds are predictable and consistent in delivering the returns of their underlying asset classes – a critical element in meeting the goals set out in a financial plan.
• Ease of understanding – Evaluating proposals by various financial advisors and brokers can be overwhelming. Every sales presentation seems to offer “best-in-class” funds that have beaten the market! Voila! But it’s easy to look backwards and highlight which funds have done well in the past. Ask the advisor how his or her fund choices from a proposal five years ago did going forward! They probably can’t answer the question as they are constantly buying and selling, chasing past performance.
The research and portfolio construction process of most active funds is complicated and lacks transparency. Financial advisors that use active funds are often not fully knowledgeable about each component in a diversified portfolio. If they can’t fully understand and explain what an active fund manager is up to, why would you even consider it?
Market-tracking funds avoid needless complexity and offer a straightforward, understandable solution. Investors know what they own (what a concept!) and can make more informed decisions.
• Tax-efficiency – Taxes can be one of the biggest drains on long-term performance. Most active fund managers do not consider the tax consequences of their trading because they are judged on pre-tax returns. According to Morningstar, the annual turnover (rate of trading activity) of the average actively managed mutual fund is 48%. (4). That’s a lot of buying and selling, and mutual funds are required to pay out realized capital gains each year. So, if the fund shares are held in a taxable (non-retirement), there are typically significant tax consequences. By comparison, the Vanguard 500 Index Fund’s annual turnover is 3.5%. (5)
• Applicability to almost any asset class – While market-tracking investing is most commonly associated with large-cap stock indexes such as the S&P 500, the strategy can be applied to almost any asset class. Index funds are available for a variety of capital market areas ranging from conservative fixed-income to emerging markets stocks.
Don’t buy into the “myth” that active management performs better in certain “inefficient” market segments, such as small cap stocks. Vanguard points out that “the reality is it’s difficult for any active manager to consistently, over long periods of time, beat any market index, because markets are dominated by other professional managers.” (6)
There is one additional benefit of index investing. We can’t quantify it, other than from the practical experience that comes from decades of working with clients. Here it is:
• Using funds that track the markets is less stressful.
Investing, by nature, brings stress. Stocks are volatile and performance is uncertain. The media highlights the crisis of the day. Short-term thinking and sensationalism seem to sell more ads than a calm, thoughtful outlook. Even for investors that do maintain a long-term focus, results are still available every day the markets are open for trading. With the advent of commission free trading of stocks and ETFs, we can now second guess ourselves from the moment we push a button.
Active management assumes all of the stress inherent in investing, and then adds more. Constantly evaluating performance of active managers, buying and selling funds, and listening to excuses or explanations produces unneeded anxiety.
Owning funds that simply deliver the return of the markets cannot eliminate all of the stress that comes with investing, just a big chunk that is unnecessary. Less stress – now that’s a return from investing that is worth pursuing!