Index Fund Anatomy Lesson
The S&P 500 Index fund has become the bugaboo of money managers throughout the world by producing excellent pre-tax returns and almost unparalleled after-tax returns. Although many have written of the inability of money managers to beat this benchmark, the systematic analysis of why this is the case has been lackluster. Perhaps it is this more than anything else that allows tabloid financial journalists to periodically craft fear-mongering stories about an S&P mania, despite the fact that only about 8% of all money invested is indexed.
The Standard & Poor's 500 is an index consisting of 500 large companies with sizable U.S. operations that is maintained by the editorial staff of Standard & Poor's, a subsidiary of McGraw Hill. Although there is no set scientific formula for how companies enter and leave the index, the editors are sensitive to including companies representative of the economy at large and tend to pull out companies in the midst of long-term decline. Although the benchmark has existed since the 1923 in some way, shape, or form, its true rise to prominence only began in the late 1980s with the explosion of the mutual fund marketing machine.
By establishing the S&P 500 Index as the de facto standard for comparing mutual fund returns, the industry ironically set itself up for embarrassing performance thereafter. It has been this embarrassing performance that has driven awareness about the S&P 500 Index funds to the masses, where institutions had been hearing that message for almost 20 years. The original academic work on index investing called it "passive" investing and determined that it was the only logical response to what was termed the Efficient Market Theory (EMT). Because academics could find no predictive factors that explained market outperformance, they reasoned that the best thing investors could do was purchase the "market."
Part of the underlying work in EMT was the discovery that money management ability, like just about any other intellectual pursuit, is distributed along the bell curve. While the distribution of performance was not perfect, most money managers appeared to cluster around the mean while there were much fewer who occupied the extremes at either end in any given year. What has not really been remarked on is why this average mutual fund performance is systematically below that available in an S&P Index fund. While some have speculated that the S&P 500 is really not representative of the market as a whole and not a good benchmark, a more subtle, but powerful reason exists that reinforces one of the basic rules for generating excess returns -- don't spend a lot of money.
By definition, a mutual fund's return is the total return of the stock minus any fees associated with investing the money. Because index funds are managed almost on autopilot, fees for these vehicles are extraordinarily low. On the flip side, managed equity funds routinely have expense ratios of 1.0% or higher, meaning that to match the market after the expenses, the fund actually has to beat the market before expenses. To beat the market clearly and decisively, the pre-expense performance has to be extraordinary. In fact, if you imagine a bell curve measuring returns that has been shifted to the left of the pre-expense mean by a percent or two to account for fees, you can easily see why, by definition, the majority of mutual funds have to underperform the benchmark.
Beyond buying an index fund, the reality of this for your portfolio is quite simple. Index funds generate market performance by keeping expenses low. In their rush to put money into the market, individual investors often run up miscellaneous expenses for trades, investment information, and software that costs them quite a bit more of their total capital than one to two percent. For each dollar you pay to invest, you have to make back that dollar plus some more in order to make any money at all. In order to beat index performance where expenses have been minimized through a pattern of long-term holding, you have to be exceptional. Although there are a few individuals that are exceptional, the majority of people are best served by concentrating on how much they spend to invest or they risk underperforming on a pre-tax basis with the same regularity as professional money managers.