Let's look at the two types of strategies used by stock funds.
- Searching for needles in the haystack - trying to find winning stocks and beat the market.
- Owning the whole haystack* - investing in all of the stocks in the market.
*"Own the haystack, not the needle" is a quote from John Bogle, founder of the Vanguard Group.
The needle approach is called "active" investing, and it's well established that most "active" mutual fund managers do a lousy job. Try as they might, most don't offer better returns than the haystack approach, which is also called "indexing" or "market tracking".
In addition to performance, there are lots of other reasons to use the haystack approach. Here's a few of them.
Haystacks offer broad diversification in a simple package
Haystack funds by definition hold most, if not all, of the securities in their particular area of the markets. Needle funds typically hold a much smaller selection of securities, typically around 150 to 250 stocks.
Holding fewer positions can add more risk. Did the fund manager make a big bet on a small number of holdings? Hopefully they will be right. But what if they are wrong?
Many investors think they are diversifying by adding several needle funds to their portfolio. Inadvertently, they end up owning the haystack, but at a much higher cost.
Owning the haystack directly - via a single fund that tracks a single market - is far more effective.
Haystacks work better in implementing financial plans
A thoughtful financial plan is the foundation for achieving financial goals over time. Since no one has an effective crystal ball, financial plans must make assumptions about risks and returns inherent in stocks and bonds – and how they perform in combination.
Looking for those needles can cause active fund managers to take on more or less risk than expected, perform worse than the overall stock market, or drift from their stated style. Their returns can then deviate significantly from those predicted by the plan. Haystack 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.
Haystacks are easy to understand
The research and portfolio construction process of most needle funds is complicated and lacks transparency. Advisors that use active funds are often not fully knowledgeable about what they are putting their clients' money into. If they can’t explain what an active fund manager is up to, why would you even consider it?
Haystack funds avoid needless complexity and offer a straightforward, understandable solution. Investors know what they own and can make more informed decisions.
Haystacks can lead to lower taxes
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%.1
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 account there are typically significant tax consequences. By comparison, the Vanguard 500 Index Fund (a well-known haystack) has annual turnover of 3.5%.2 Lower turnover = lower taxes.
Haystacks are just about everywhere you want to invest
While haystack investing is most commonly associated with large-cap stock indexes such as the S&P 500, the strategy can be applied to almost any area of the markets. Large company stocks, small company stocks, international stocks, real estate investment trusts ...
Don’t buy into the “myth” that active management performs better in supposedly “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.”3
Haystacks are less stressful
Have you ever been stressed out while looking at a haystack? I doubt it. Digging through one to try and find a needle might be another story.
Investing, by nature, brings stress. Stocks are volatile and performance is uncertain. The media highlights the crisis of the day. Sensationalism sells 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.
Active management assumes all of the stress inherent in investing, and then adds more. Constantly evaluating the performance of active managers, buying and selling funds, and listening to excuses or explanations produces unneeded anxiety.
Haystack 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!
David Rappaport, CFP®