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The Case for Index Funds

On Wall Street, the goal of every hedge fund manager is to outperform the market by providing superior returns for that manager’s clients. A good hedge fund manager generally aims to be an expert at identifying market risks, timing market opportunities to buy and sell securities, stay up to date on economic news in the US and globally, and ultimately maximize returns and minimize losses. Many hedge fund managers fail to accomplish these goals, and yet their investors pay a large expense to have their assets managed by the hedge fund. The same problem can exist with actively-managed mutual funds as well: high expense ratios and common under-performance of the fund compared to its benchmark. So why would you invest in a hedge fund or actively managed mutual fund trying to beat the market rather than invest in a low-cost index fund or exchange-traded fund (ETF)? That’s a great question! While there are certainly some advantages to buying actively-managed mutual funds, we are going to look at some of the arguments for being an “index investor.”

What is an “index investor”? An “index” is simply a benchmark that tracks a certain market or portion of the market. Some of the most well-known indices are the Dow Jones Industrial Index, the NASDAQ, and the Standard & Poor’s (S&P) 500. While one cannot buy a share of the Dow or S&P 500 per se, passively managed index funds and ETFs are designed to follow, as closely as possible, the performance of the major market indices. If you wanted to own a fund that performs nearly identically to the performance of the S&P 500, you could buy a share of the Fidelity 500 Index Fund (ticker symbol FXAIX). Owning FXAIX instantly gives an investor a stake in the 500 largest US companies, following their aggregate market performance without having to break a sweat beyond clicking “buy” through a brokerage firm’s website. Low-cost index funds and ETFs exist for virtually any sector of the US and global market (for more on market asset classes, go here). There are some major advantages to investing using an index fund approach. Here are 4 good reasons to invest in index funds:

1. Low Cost

Actively-managed funds are funds in which a manager is actively choosing which stocks and investments the firm or fund is choosing to invest in. A fund’s turnover ratio indicates how often the manager is actively changing the investments that make up that fund. Because a manager is actively involved and turnover of assets is often high, the costs associated with such a fund is typically much higher than the typical index fund. The costs an investor pays are expressed in a fund’s expense ratio, essentially a percentage of the assets that the investor will pay each year. The chart below from The Balance in October 2020 shows the average expense ratios of major fund categories.

Source: The Balance

A general rule of thumb is that an expense ratio over 1% is considered “high,” but as index funds and ETFs have exploded in popularity over the last two decades, expense ratios have plummeted as competition has increased between various investment firms trying to win over investors. Passive index investing takes the guesswork out of managing the fund. The fund management essentially buys the stocks of the companies in the index that fund is tracking, usually weighted by the market capitalization (the total stock value of a company) of all the companies in the index. The manager or management team is not seeking to outperform the index by identifying hot or cold companies to buy and sell, but rather just mimic what the market is doing. Because of the simplicity of managing such a fund, many index funds have expense ratios of 0.20% or less. In fact, the fund FXAIX has one of the lowest expense ratios of any S&P 500 fund at just 0.015%. In other words, for every $1,000 you invest in FXAIX you would only pay $15 in expenses each year.

2. Broad Diversification

Enron is perhaps one of the most famous examples of a company that went belly-up due to fraud and mismanagement, costing investors billions of dollars. Aside from risk of fraud and poor management, investors take on many other risks when investing in publicly-traded companies. An investor who holds stock of a company may see major losses due to the company's competition, overleveraging, lack of profitability, economic crises, and many other possible risks to the company’s success. Some argue that the greater the risk, the greater the reward. There is a lot of truth to that, and investors often pay a premium on the additional risk they are willing to take on. But the inverse is true as well: the greater the risk, the greater the potential loss. A major advantage of investing in index funds is the broad diversification an investor has to hundreds and thousands of companies rolled up into a single fund. FXAIX, for example, has about 500 companies in its holdings, as it tracks the S&P 500. The Vanguard Total Stock Market Index Fund Admiral Shares (ticker VTSAX), which tracks the entire U.S. stock market, has over 3,500 holdings. If a company within that index’s holdings goes under, it has little impact on the overall performance of the index fund. For very little cost, an investor owning an index fund instantly has access to a broad, diversified portfolio of hundreds or thousands of companies with significantly less risk.

3. Be the Market

Because index funds track various market benchmarks, investors can pick and choose index funds which track the asset classes they want to own: emerging markets, commodities, large cap growth stocks, long-term Government bonds, etc. Index fund investors have low-cost access to large sectors of the market, even the entire global stock market (such as the Vanguard Total World Stock Index Fund Admiral Shares, or VTWAX). Such diversification allows investors to achieve returns nearly identical to the overall market or sector of the market each index fund they hold tracks. Instead of trying to guess which companies or funds to own to outperform the market, owning an index fund allows you to “be the market.” Before you go out and buy any index fund, just make sure to check an index fund’s “tracking error,” which measures the fund’s ability to follow its benchmark index. Some index funds track their indices better than others, which can potentially affect overall performance of one fund versus another similar fund.

4. Long-term performance

As seen in the U.S. stock market history since the Great Depression, the stock market generally rises over time. The Dow Jones Industrial Index, once at 380 in 1929, is now well above 30,000! An investor who buys and holds an index fund over the long-haul will most likely outperform an investor who buys and sells specific securities to attempt to time and beat the market. Even actively-managed mutual funds, managed by experts at picking stocks, usually cannot beat their benchmarks. In 2019, for example, less than 50% of actively-managed funds beat their benchmarks, per this January 2020 article published by Barrons. It is astonishing that a beginning investor, for pennies on the dollar, can buy an index fund that tracks a specific benchmark and outperform at least 50% of active fund managers who are paid top-dollar to attempt to beat the same benchmark. The long-term performance of various stock market indices, especially when compared to actively-managed funds, is a compelling reason to stick with index funds.

In summary, while you can certainly find well-managed mutual funds, hedge funds, and put in the time and research to pick winning companies to invest in, it is usually a lot easier, cheaper, and safer to invest in index funds. Also, the overall market’s long-term track record of performance is continual growth. There are many nuances and arguments on both sides of the index fund debate, but index funds remain one of the best investment options available to investors today.

In our next blog post, we will identify some simple portfolios using index funds that you can easily implement yourself. Stay tuned!

Disclaimer: The opinions and views expressed by the author do not constitute investment advice or recommendation, and are provided solely for informational purposes, and are not an offer to buy or sell any securities. Always conduct your own research and due diligence before making any investment decisions.

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