Index Funds

I recently came across a conversation on the Bogleheads Forum in which somebody referred to me as an “indexing extremist.”

At first it just made me laugh. I have a hard time seeing myself as an anything extremist given the quantity of parenthetical explanations and qualifiers (“generally,” “usually,” “tends to,” etc.) that I tend to use.

But the more I thought about it, the more I realized that it’s possible (likely?) that I’ve overstated (or misstated) the case for index funds.

Let’s back up a step in the hope of clearing things up.

The Magic of Indexing?

There’s nothing truly magical about indexing. Or, if there is, it’s just that it’s a very inexpensive way to run a mutual fund without having to sacrifice diversification.

There are some other, less important benefits — like not having to worry that your fund manager will do something dumb with your money. But low costs are the big thing here.

There’s no particular reason to think that having a portfolio in which each investment is weighted according to its market weight is in itself, going to improve your returns. In fact, for most investors, it doesn’t make sense to market-weight your entire portfolio. For example, consider your bond allocation:

• For investors in high tax brackets investing in taxable accounts, it makes sense to overweight tax-exempt bonds.
• Conversely, for investors exclusively using tax-sheltered accounts (IRA, 401(k), etc.), it makes sense to underweight tax-exempt bonds — all the way to zero, most likely.
• For investors who are very exposed to inflation risk, it likely makes sense to dramatically overweight TIPS relative to their market weighting.

In other words, we each have different needs. And as a result, it makes sense for each of us to hold a portfolio that’s different from the market portfolio in one way or another.

Costs Matter.

But index funds (and ETFs) do tend to be the least expensive way to invest. And as it turns out, that’s no small benefit.

As Russel Kinnell of Morningstar wrote last year when summarizing a study he’d done,

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

Or consider an earlier study, also from Morningstar:

“In all categories, funds in the cheapest quintile were more than twice as likely to succeed–that is, beat the average for their categories-than those in the most expensive quintile. Success declines rapidly as you move up in price. Of domestic-stock funds, 47% in the cheapest quintile succeeded over a 10-year period, 33% of the next cheapest quintile succeeded, 30% of the middle quintile succeeded, 27% of the second priciest quintile succeeded, and just 19% of the most expensive quintile beat the category average.

That same general conclusion has been shown by study after study: Lower-cost funds tend to outperform higher-cost funds.

And because index funds and ETFs tend to be the lowest-cost option available, they’re usually a darned good bet.

October 3, 2011 12 comments

In reply to our recent discussion of index funds and management risk, I received an email that began with the following assertion:

“The problem with indexing is that it only works in bull markets. Active management will outperform when the market moves down.”

The email went on from there to make other questionable arguments, but I wanted to tackle this one because a) I hear it relatively often and b) it’s demonstrably false. (More precisely, the second part of the assertion is demonstrably false. The first part naturally depends on what exactly the writer means by “works.”)

As Nobel Prize winning economist William Sharpe pointed out twenty years ago in “The Arithmetic of Active Management,” after accounting for costs, the average passively managed dollar in a market will by definition outperform the average actively managed dollar in that market.

It Works Like This…

By definition, passive investors hold the market portfolio. That is, they hold each stock in proportion to its market value. So if, for example, Apple currently makes up 2% of the total value of the U.S. stock market, a passive investor will allocate 2% of his/her U.S. stock portfolio to Apple.

Therefore, active investors must as a group hold the market portfolio as well. That is, if one active investor has chosen to underweight Apple relative to its market valuation, that’s only possible because another active investor has chosen to overweight Apple.

Conclusion Part 1: Before considering costs, each passive investor will earn the market return (because he/she holds the market portfolio). Similarly, before considering costs, active investors will as a group earn the market return (because, as a group, they hold the market portfolio).

Conclusion Part 2: After considering costs, each passive investor will earn the market return, minus whatever they pay in investment costs (say, 0.2% for a decent index fund). And, after considering costs, active investors will as a group earn the market return, minus whatever they pay in investment costs (sales loads, brokerage commissions, actively managed fund expenses, etc.).

Conclusion Part 3: Because active investors pay significantly higher costs than passive investors, they must earn a lower average return per dollar invested.

Takeaway: For each portion of your portfolio (U.S. stocks, international stocks, bonds, etc.) if you invest in a low-cost index fund, you will outperform the average actively managed dollar for that category of investment.

It’s Mathematical Certainty

There are very few things in the field of investing that can be said with certainty. But this is one of them. It holds true in every market. And it holds true over every period of time, regardless of whether that period is a bull market or a bear market and regardless of whether that period is a day or a decade.

It doesn’t depend on market efficiency. And it doesn’t depend on active fund managers making stupid decisions. All it depends on is plain, simple math. (John Bogle calls it the “relentless rules of humble arithmetic.”)

Picking Mutual Funds

Of course, due to the sheer number of funds in existence, there will always be plenty of funds that outperform their index over any particular period. (The shorter the period, the more outperforming funds there will usually be.)

But as the Standard & Poor’s Indices Versus Active scorecards have been showing us for several years now, most actively managed funds do not manage to beat their benchmarks–even during bear markets.

And there’s an abundance of data showing that sticking with low-cost funds is a winning strategy. As Russel Kinnel (Morningstar’s Director of Mutual Fund Research) puts it, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. … They are still the most dependable predictor of performance.”

May 9, 2011 6 comments

Target retirement funds (aka target date funds) are meant to be a one-fund solution to investing. Many investors, however, are somewhat reluctant to put everything in a single fund. It just doesn’t feel diversified.

I would argue, however, that if you can find a target retirement fund with an asset allocation and “glide path” (projected asset allocation over time) appropriate for your level of risk tolerance, it can be perfectly OK to use that fund for your entire portfolio.

Important note: Do not pick a target date fund based on the date in the name. Pick based on the fund’s asset allocation. You may find that the fund that best fits your own tolerance for risk is the one typically intended for investors retiring 10 or 15 years earlier or later than you.

Vanguard’s target retirement funds* are portfolios comprised of Vanguard Total Stock Market Index Fund, Vanguard Total International Stock Index Fund, Vanguard Total Bond Market Index Fund, a small money market holding, and (in the most conservative of the target funds) Vanguard Inflation-Protected Securities Fund.

According to Vanguard’s site, as of 3/31/2011:

• Vanguard Total Stock Market includes 3,380 stocks,
• Vanguard Total International includes 6,517 stocks, and
• Vanguard Total Bond Market includes 4,907 different bonds.

In other words, with just one target retirement fund, you can achieve an extreme level of diversification–almost 10,000 stocks (spread across several different countries), plus a diversified portfolio of bonds. In my opinion, that’s as diversified as anyone needs to be.

Target Retirement Fund Drawbacks

Of course, target date funds have their drawbacks too.

First, if your portfolio is large enough, you could achieve slightly lower expenses by using individual funds–Vanguard Admiral shares or ETFs, or Fidelity Spartan funds, for example.

Second, for investors in taxable accounts, target date funds could be less tax-efficient than a portfolio created of separate funds. For example, an investor in a high tax bracket could benefit from using tax-exempt municipal bonds rather than the taxable bonds included in a target retirement fund.

Finally, there’s no guarantee that the fund company will stick to the planned glide path. That is, the current plan may be for the fund to have a certain allocation 15 years from now, but the fund company can change that plan at any time. The result: An investor who is a little too oblivious could end up with a different allocation than he/she had anticipated.

Simple Yet Sophisticated

Despite the above imperfections, a single Vanguard target retirement fund (checked periodically to make sure the allocation and projected glide path are still in line with your goals) is actually a quite sophisticated portfolio for an investor in a tax-sheltered retirement account. They offer extreme diversification and automatic rebalancing, all for an expense ratio of less than 0.2%.

Not bad, if you ask me.

*Except in an employer plan, I wouldn’t use any target retirement funds other than Vanguard’s. According to Morningstar, Vanguard’s target funds cost just 0.18% per year. The next-cheapest company (Wells Fargo) charges three and a half times as much (0.63%), and it only gets worse from there.

Update: iShares also offers a line of target date ETFs that was apparently excluded from the Morningstar study. With expense ratios of 0.29%, they’re decidedly lower-cost than most of the competition, though still pricier than Vanguard.

May 4, 2011 3 comments

The Fairholme fund is an actively managed mutual fund run by a fellow named Bruce Berkowitz. Since the fund’s inception in 1999, Berkowitz has had an impressive run. According to Morningstar, the Fairholme fund is in the top 1% of funds in its category (large-cap value funds) for both 5-year and 10-year annualized returns. That’s quite an achievement!

However, as esteemed investment author Taylor Larimore recently pointed out, the fund’s performance has been rather lacking over the last year. In fact, it’s been pretty bad. For the twelve months ending 4/29/2011, Fairholme is in the bottom 1% of funds in its category. Yikes.

So what does that mean for investors in that fund? Is Berkowitz’s hot streak over? Or is this just a short-term hiccup in what will turn out to be another decade of superstar performance?

I have no idea.

And that’s the point.

Actively Manged Funds: You Can Never Be Sure.

When you own an actively managed fund, there will be periods during which your fund underperforms its benchmark and its peers–sometimes dramatically. When that happens, you have to decide whether or not you want to continue holding the fund, which means trying to determine whether:

1. The poor performance is just a fluke and your actively managed fund’s performance will soon pick back up,
2. The fund manager has “lost his touch.” (For example, he had previously succeeded by exploiting a particular market inefficiency, but that inefficiency has now become public knowledge, rendering it ineffective and leaving your manager scrambling to find a new trick.),
3. The fund has grown so large that the fund manager can no longer handle it effectively, or
4. The fund manager was never anything but lucky in the first place, and his luck has now run out.

Years later, with the benefit of hindsight, you may be able to tell which of those scenarios was actually the case. But while it’s actually happening, all you can know with certainty is that your fund is losing money and falling behind its peers.

Yet Another Reason I Like Index Funds

When you invest in index funds, the overwhelming majority of your funds’ performance will be explained by two things:

1. The performance of the underlying indexes, and
2. The funds’ costs. (Lower costs = better returns.)

As a result, you don’t have to spend time researching fund managers. You don’t have to spend time trying to determine whether a particular manager is skillful rather than just lucky. And you don’t have to spend time worrying about whether your fund’s manager has “lost his touch.”

Truth be told, I don’t even know the names of the people who run the funds I own. It’s not that I don’t appreciate their work. It’s just that the information isn’t particularly relevant to what I do with my portfolio.

If you’re an index fund investor, management risk–the risk that your fund’s performance will be harmed by the manager’s poor decisions–is one thing you don’t have to worry about.

May 2, 2011 7 comments

Over the last few years, I’ve had accounts at just about every brokerage firm you can name–Schwab, Fidelity, Vanguard, ETrade, Scottrade, TradeKing, and a whole list of others.*

And over the last year, I’ve consolidated everything at Vanguard.

To be clear, Vanguard is not the only reasonable choice. Low-cost, diversified portfolios can be built just about anywhere these days. So, while my own portfolio consists of four Vanguard index funds, I’d be perfectly happy with this portfolio of commission-free ETFs at Schwab, for example:

• Schwab U.S. Broad Market ETF
• Schwab International Equity ETF
• Schwab Short-Term (or Intermediate-Term) U.S. Treasury ETF

…or this index fund portfolio at Fidelity:

• Spartan Total Market Index Fund
• Spartan International Index Fund
• Spartan Short-Term (or Intermediate) Treasury Index Fund.

So Why Do I Use Vanguard?

I prefer Vanguard because of their unique ownership structure. You see, Vanguard is owned by the mutual funds it runs. (This is in contrast with other brokerage firms and fund companies, which are owned by third-party shareholders.)

Believe it or not, this isn’t just trivia. It has important ramifications.

Low Costs

First and most obviously: It makes their funds very inexpensive. All of Vanguard’s services are provided “at cost” to investors. And why wouldn’t they be? The investors essentially own the company.

Cost Reduction (rather than Profit-Maximization)

Second, it means that Vanguard is always looking for ways to reduce costs even further. Contrast this with other brokerage firms, and you see a big difference.

For example, discount brokerage firm Zecco became known for offering commission-free trades to people with accounts of $25,000 or more. They recently announced, however, that they’re ending that program completely. Tough luck to everybody who opened accounts for exactly that reason.

With Vanguard, you don’t have to worry about bait-and-switch tactics like that. You don’t have to worry about them roping you in with a low-cost promotion, then jacking up prices to increase their profit margin (because, again, there is no profit margin).

Elimination of Conflicts of Interest

Finally, Vanguard’s unique ownership structure means that the information investors receive from them is not polluted by conflicts of interest.

As a contrasting example, with my account at Schwab, I frequently received emails (as well as their quarterly On Investing publication) that encouraged me to seek above-market returns by trading individual stocks or selecting actively managed mutual funds. I daresay it’s not a coincidence that frequently trading stocks and investing in high-cost funds happen to be strategies that are more profitable for Schwab than buying and holding index funds.

My experience was similar with other brokerage firms: They consistently encourage their clients to use investment strategies that are most profitable for the brokerage firm, regardless of how likely those strategies are to be successful for the investor.

At Vanguard, it’s different. I don’t agree with every piece of information they put out, but at least I don’t have to worry that they’re trying to get me to do something just because it’s more profitable for Vanguard.

*I do not recommend having accounts at several places. I did it for business purposes–so that I could write intelligently about several different companies–rather than investment purposes. As an investment decision, it makes little sense.

March 7, 2011 15 comments