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Index Funds are Mediocre

A friend of mine recently told me that she was about to start using a new financial advisor, but she wanted to ask me what I thought of the advisor’s company before she wrote him a check.

The short version is that the advisor was a broker who was trying to sell her a portfolio of super-expensive, actively managed mutual funds. She explained:

“I asked him about index funds, since I know that’s what you and a lot of other people recommend. He said that index funds are mediocre because there’s no chance that they’ll outperform the market.”

The cynic in me couldn’t help but chuckle a bit. “Index funds are mediocre.” It’s a staple soundbite for brokers. Back when I was a broker, I used it all the time.

Hearing that phrase again got me thinking about all the ways that index funds are mediocre. I thought I’d share a few here.

Index Funds are Mediocre

Index funds are mediocre…if mediocrity means being able to obtain extreme diversification with as few as three holdings.

Index funds are mediocre…if mediocrity means being significantly more tax-efficient than almost every actively managed mutual fund on the market.

Index funds are mediocre…if mediocrity means outperforming 60% of U.S. equity funds over the last 5 year period, 60% over the period before that, and 66% over the period before that. (The results are even more impressive for bond funds and international stock funds.)

Index funds are mediocre…if mediocrity means never needing to check your funds to see if any of their managers retired or went to other firms.

Index funds are mediocre…if mediocrity means knowing how your money is invested because your fund company has no reason to keep the fund’s holdings a secret.

Index funds are mediocre…if mediocrity means never having to look at stock charts, watch for earnings reports, or read financial statements.

Index funds are mediocre…if mediocrity means being able to retire with 25% less money (because you’re not spending a quarter of your 4% withdrawal rate just to pay your fund manager).

Index funds are mediocre…if mediocrity means never having to worry that your (seemingly) skilled fund manager will turn out to have just been lucky…and that you won’t find out until his luck runs out.

Index funds are mediocre…if mediocrity means knowing with mathematical certainty that your money will outperform the average actively-managed dollar over every period.

Mediocre sounds pretty good to me.

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Comments

  1. Hi No’am.

    Here’s my understanding (somebody can correct me if I’m wrong).

    Traditional open-end mutual funds (including index funds) are priced at their net asset value (NAV) — that is, the total value of the fund’s assets, divided by the number of shares. So it’s a direct function of the prices of the investments that the index fund owns.

    With exchange traded funds (ETFs), it’s not. ETFs are priced on the open market, at whatever value investors are willing to pay for them. That said, the market price of an ETF will very closely track the prices of the underlying investments, due to the fact that, if the price of the ETF were to stray significantly from the underlying value, institutional investors would step in to take advantage of the arbitrage opportunity, eliminating the difference between the market price and the underlying value almost immediately.

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