What are Index Funds?
Index funds are mutual funds that track a predefined basket of stocks or bonds that make up a certain asset class. For example, the S&P500 is an index of the largest 500 stocks in the U.S. stock market. There are indexes set up to track all sorts of assets classes like smaller stocks, international stocks, bonds, real estate stocks, emerging market stocks, and many, many more.
What are Active Funds?
Active mutual funds typically invest within a particular asset class but have investment managers that choose, buy and sell specific investments that they feel will have the best chance to outperform their index. But, to do this, the funds have to incur costs, which could include salaries, travel and bonuses of the managers and research staff, transaction fees on each trade, and commissions to the person selling you the fund.
Index funds benefit from very low costs as they do not have to spend the money the active funds do. However, an index fund by definition, should never outperform their benchmark but will always come very close to it. They should underperform by about the amount of their costs. Their costs are very, very low, but they are not free and those costs get paid by the investors.
Perhaps you are thinking: “But I don’t want to be just average. I’m looking for above average and I’m willing to pay a manager to do that for me. Why would you recommend a plan that you know will never beat the market?”
Here is an illustration that may help.
The Three Bets
Let’s say I represent all the stocks in an asset class (I’m the indexer) and you represent the investors trying to pick the right group of stocks (you are the active investors). The asset class as a whole will produce an average return of some amount. By definition, half of the money invested will do better than that average return and half will do worse.
So here is the bet to represent that.
- We flip a coin… heads you win $10 from me, tails I win $10 from you.
That’s a fair bet and, done many times over many years, you should win about half the time and I should win about half the time. Hey, index investing does produce average returns!! But hang on a minute. What if you had to pay the Coin Flipping Commission 15 cents before every flip and I had to pay them a penny? It would then be a whole lot harder for you to beat me over the long term...unless you have the coin flipping skill to make the coin land heads more than half the time for a long time.
And so it is with active funds. The expenses they incur (and pass through to the investor) are a huge disadvantage, making it much more difficult to produce index beating returns. As for the stock picking or market timing skills, multiple studies show little to no evidence of persistent outperformace1. There may be exceptions but identifying the next Warren Buffett or Peter Lynch in advance is very difficult.
For these reasons, the bet for active vs passive ends up more like this:
- We roll a standard die. If it comes up 1 or 2, you win $10. If it’s a 3, 4, 5 or 6, I win $10.
That’s right, studies show that index funds historically outperform the large majority of active funds, year after year and the outperformance gets more pronounced as the time span increases. In a recent publication by Vanguard1, they report that for the ten years ending 2013:
- U.S. stock index funds beat about 85% of active U.S. stock funds
- U.S. bond index funds beat about 80% of active bond funds
- International stock index funds beat about 72% of active international funds
Now, this bet might be worth taking if the payout for picking the winning funds was huge compared to the under-performance for losing. But studies, including a recent paper co-authored by Rick Ferri2, show this is not the case. In fact, the study showed that the median excess return when picking winning funds was actually quite a bit less than the median shortfall by picking losing funds.
In other words, our bet is now getting worse for you.
- We roll a standard die. If it comes up 1 or 2, I pay you $10. If it’s a 3, 4, 5 or 6, you pay me $20.
I don’t imagine there would be any takers for this bet. The same logic should be applied to investing. Active funds can outperform their market index and some do every year. However, the odds of you picking the right fund(s) in advance are so low that it’s not rational to take that bet.
1Vanguard’s Principle’s for Investing Success, 2014
2RICHARD A. FERRI, CFA and ALEX C. BENKE, CFP®, A Case for Index Fund Portfolios – Investors holding only index funds have a better chance for success, June 2013
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