Why is Index Investing a “No Brainer”?

For those of you who have read much of my writing on the subject, you’ll recall that I always recommend working with index investments when we have them available.  In this article I will do my best to help you understand some of the reasons why I make that recommendation.

What is Index Investing?

In order to understand why indexes make the best investments, I need to explain first what I mean by an index.  In general, an index investment is a representative investment covering a market, sector, or asset class.  The S&P 500 is an index, representing the asset class of the 500 largest publicly-traded companies in the US marketplace.  The Vanguard Total Market Index is an index that represents the entire spectrum of domestic (US) publicly-traded companies.  There are many other examples, including the Lehman Brothers Aggregate Bond Market Index (all publicly-traded bonds in the US marketplace) and the Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East (EAFE) index – which includes the entire markets of the following countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, The Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.  Since these indexes represent the entire marketplace, they are used as the benchmark against which managed funds are measured.

There are mutual funds and exchange-traded funds that track these various indexes.  If you’ll recall, one of the first tenets of successful investing is to diversify – don’t put all of your eggs in one basket.  By investing in one of those vehicles, the investor is taking an ownership stake in all of those companies at once.  What a great way to diversify!

These indexes do not change, and do not require a professional manager to oversee them, because they represent an entire marketplace.  Because of this, there is very little overhead (fees and expenses) to reduce your return.  Also, since we aren’t changing investments by selling a company’s stock that is out of favor and buying one that we think might provide better returns in the future, transaction costs are nil, and excess taxation is eliminated from the mix.

What Are Managed Investments?

On the other side of the coin from Index Investments is the group of mutual funds called Managed Investments.  These are investment vehicles where a manager (or team of managers) chooses a group of companies (or bonds) to invest in.  Over time, this group of investments must be monitored to ensure that the individual companies are producing the expected results.  If a company appears to be underperforming, that stock is sold and another company is chosen to replace it in the fund.  All of this analysis requires lots and lots of research, review, and just day-to-day management.  And that management costs a lot of money – often upwards of 1% of the fund’s holdings each year – as opposed to less than ¼% for many indexed funds.

The idea is that the professional management team is a bunch of very smart guys and gals, and being very smart guys and gals, they can get you a better return than you could get by just buying an index fund.  Care to guess how often that happens, consistently?  Less than 5% of the time, according to records, and that doesn’t include all of the funds that are eliminated or merged due to underperformance.

So – the first “wrong” with investing in managed mutual funds is that you’re taking a chance that your smart guys and gals (the managers of the fund you’ve chosen) will happen to be in that top 5% that beats the index investment.  And you’re paying something like four times (or more) in expenses to get there.  But people still love a gamble, and so managed funds remain very popular.  But why?

Under The Covers

Let’s take a look at why some managed mutual funds appear to be a good gamble, when in fact they’re really just fooling you.

Mutual fund companies introduce lots of funds every year.  As an example let’s say a fund company introduces ten new funds in the year.  Each fund has a fair-haired boy (or girl) managing the fund, and the manager does his or her level best to produce a good return.  For the most part, since these funds haven’t been marketed to the public, the fund company puts some of their own money in the fund;  this is called “incubation”, it’s a way for a fledgling fund to build a track record before investment of a lot of money in marketing.  At the end of the year, nine of the ten new funds have poorly underperformed, but one of the funds outperformed the indexes by a wide margin – let’s say it’s by more than 20%.

The nine poor-performing funds’ monies are merged with the one winner fund, bolstering it’s asset size, and the marketing begins.  Investors hoping for that “one in a million” investment are drawn to this new fair-haired investment manager because of the fantastic return that her guidance produced in the past year.  Now is when it gets interesting…

The Interesting Part

Remember when I mentioned before about how less than 5% of all mutual funds consistently outperform the entire market index?  That’s because it is very difficult to individually pick and choose 50 or 100 companies that will do better than the market.  The entire market has a track record of increasing in value over 80% of the time, year in and year out.  Imagine trimming that 10,000+ group of investment choices to a manageable group of 50 to 100 stocks (or bonds) that will do better than everyone else!  It’s very, very, difficult, indeed – and most managers do not do this – and certainly not consistently.

So, what happens is that after the fund has had it’s initial “home run” season, where it outperformed the market by 20% or more, is that the fund attracts all kinds of attention and investors.  So in the second year, lots more money pours into the fund, and the manager does her best to reproduce the result from the previous year.  Amazingly enough, she does it, but this time only by about 2% overall – and the expense ratio of the fund eats one percent right away.  But look at her track record:  over the span of two years, she’s outperformed the index by an average of 11%!  Why would you NOT invest in this fund??

After the second year where the manager just squeaked out a positive result, not wanting to lose investors’ funds, she becomes more conservative – now she begins to more closely track the index against which her fund is compared, rather than whatever magic was used to produce the first year’s stellar results.  At the end of this year, the fund doesn’t quite meet the index’s return, but it’s pretty close (until you take out the additional 1% of expenses).  But again, the marketing points out that, over a three-year period, this manager has outperformed the index by almost 7%.  Again – you’d be a dummy to not invest with that kind of result, right?

And so it goes… eventually this fund’s returns each year are always coming up just short of the index, and after a good run of five years, the fund is folded into the next best thing.  Lather, rinse, repeat…

Backing Data

I wanted to give you some additional data on the above activity, so I ran some screens using readily available tools (like Yahoo! Finance, Morningstar, etc.).  The results were quite interesting:  on one screener I looked for funds that had been in the top 20% of all funds for each of the past five years.  Result?  Zero.  No fund in the investing universe was in the top 20% for five years running.

So next, I looked at all funds created during calendar year 2003, and took their rankings for 2004, 2005, 2006, 2007 and 2008.  Not one of the funds that was in the top 50 for 2004 repeated for all five years, and only 1/3 of that top 50 ever showed up again in the top 50 for the succeeding four years.

Lastly, I took that same group of funds created in 2003, and compared results against the S&P 500 index’s returns for each year, 2004 through 2008.  Not a single fund was present in more than one of the years as an index-beater.

Of course this isn’t definitive research – I’ve found it doesn’t pay off to spend too much time checking these things out, because the result remains the same.

One other item that was not factored in is called survivorship bias.   This is the phenomenon that occurs because only the surviving funds, those that had good performance, are available for result comparison.  From our example, nine of the ten new funds created by our fictitious mutual fund company were shut down after the first year.  So now, being non-existent, the poor results that those funds brought forth are not included in any screening reports, making the results (of only the surviving funds) look much better overall.

Bottom Line

At any rate, I wanted to provide you with this explanation of yet another problem seen in the investing world.  I think it can best be summed up by comparing investing with gambling at a casino.  Everyone knows that gambling odds are always in favor of the “house”.  The individual gambler might hit it big once in a blue moon, but in general the gambler pretty much always comes out on the short end.  On the other hand, with the odds in the favor of the casino, owning a casino can be a pretty good way to make a lot of money.

In the investing world, it pays off to own the “casino” – that is, to own the entire marketplace – instead of playing the games of managed mutual funds.  Owning the marketplace (via an index) gives you the benefit of an 80% opportunity for an increase in your holding each and every year, for a very low expense ratio.

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Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author