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Index Funds: Still Your Best Bet

There was a time when I began each article stating that the best place for most individual investors to keep their money was in index funds. I still believe this -- I just fell out of the habit of writing it. So, for the record:

The best place for most individual investors to keep their money is in index funds.

Yes, index funds -- those Garrison Keillor "everyone is above average," sepia-toned, Muzak-listening vanilla cousins of the rough-and-tumble equity markets. They offer the best chance for most investors to outperform their peers. Not mutual funds, not individual equities, not hedge funds, not "trading system" shenanigans. Index funds. Let the performance and action junkies jump up and down and pretend like they never have a bad trade. They do -- by the boatful. The index fund route lets investors capture market averages and diversify, and then go off and do other things with their lives. Berkshire Hathaway's (NYSE: BRK.A  ) (NYSE: BRK.B  ) Charlie Munger once said that a life spent swapping pieces of paper back and forth is no life at all. What does that say about investors who buy the market once and then get on with their lives?

After publishing Nathan Slaughter's The Case Against Index Funds, I think the Fool needs to restate something it has said since its founding more than a decade ago: If you invest (which you should), and you invest in index funds exclusively, you've improved your chances of financial security. I think this component is lost in the day-to-day chatter of "this company did this, this company has such-and-such potential, this mutual fund beat its benchmark for the last so-and-so years." It's lost because there's a much greater audience for ongoing coverage and analysis of equities. It's lost because coming to any website for coverage on an index fund sorta defeats the purpose, don't you think?

This isn't to say that we haven't tried. Who among you remembers Harry Jones, our taciturn Nebraska farmer?

Hey, cool! Dry paint!
Index investing is a bit like watching grass grow. It doesn't require much oversight to take place. Writing about index funds every day is a bit like playing polka music at a rave -- the audience you seek is at the Veterans of Foreign Wars Hall down the road, and the one you're playing to finds you irrelevant and annoying. But just as all rave music has its roots in polka, the essence of do-it-yourself investing, as espoused by The Motley Fool, is putting your money into index funds. OK, forget about the polka analogy. Just roll with me.

So, I was a little disheartened to see our Fool heritage so thoroughly trashed in Nathan's article. He noted -- and we should be fair here -- that his opinion was going to be controversial even within the ranks of the Fool editorial staff. Yeah. Right here. Now Nathan's contributions to the Fool have been extraordinary -- case in point, his read of Charles Schwab (NYSE: SCH  ) far outstripped my own recent take on it. But I think he missed the mark on this article. What's more important, given the dearth of recent coverage on index funds on the Fool, I think that it leaves the impression that we're backing away from a decade's worth of what I see as an extraordinarily strong piece of advice: The index fund remains the most efficient and among the best ways to invest. It remains the best way to say "I don't know what's coming next." It is also a great way to say "And I really don't care."

To my mind, Nathan made three honest errors in compiling his article. First, he begins by discarding every index fund save for the Vanguard S&P 500 (FUND: VFINX  ) , which tracks the performance of the S&P 500. This is a natural -- for the majority of people, the words "index fund" and Vanguard 500 are nearly synonymous. But in the last five years, hundreds of financial instruments tracking various indexes -- domestic, international, open-ended funds, or exchange-traded funds, equity, bond, preferreds, even commodities -- have come into existence. So when you wish to talk about diversification, which Nathan did, it makes no sense at all to ignore 99% of all of the instruments of the index fund universe. Looking for bond exposure? iShares Lehman 20+ Year Bond Fund (AMEX: TLT  ) perfectly fits the bill. For exposure not just to large caps but the totality of the publicly traded companies in the U.S., you could elect to buy the Vanguard Total Stock Market VIPER (AMEX: VTI  ) , or you could pair an S&P index fund with a small-cap one such as the iShares Russell 2000 (AMEX: IWM  ) . International equities and debt, corporate and sovereign, can be addressed using index funds.

Were there only one flavor of index fund out there, this criticism would be valid. But there are hundreds of different passively managed products to build an entire portfolio around. According to a John Bogle speech from April, there are now 430 equity index funds and 30 bond index funds.

Indexed diversification? Heck, yeah!
Read Nathan's diversification myth again, and you'll see that he mentions plenty of other alternatives to the S&P 500, but then he notes that investors believe they are diversified with the S&P 500, along with a few other things. But what he repudiates is not the thought that index funds writ large offer insufficient diversification, but rather that ones specifically tracking the S&P 500 do. That's a different argument.

Does the S&P 500 offer sufficient diversification at 80% of the total capitalization of the U.S. stock market? Not even Bogle, the father of the index fund movement, believes this to be the case anymore. But can a well-diversified portfolio be put together only using index funds? You bet.

The second error is actually one in combination -- it is used to refute the statement: "In the long run, passive investing nearly always beats active investing." Nathan uses a fairly short period of time to show that plenty of mutual funds have beaten the S&P 500 benchmark. Let's see, 1,700 have outperformed over the last five years and 300 over 10 years.

A few questions come to mind. The first, of course, is whether the S&P 500 is the appropriate benchmark for all of these funds. A fund that picks small-cap stocks ought to be compared to the Russell 2000, one that picks stocks in Japan's Nikkei 225. But there are two bigger problems. First, these numbers of outperformers don't have any context. If 300 funds have beaten the S&P 500 over a decade, that's certainly a noteworthy length of time. But this is out of how many funds that existed a decade ago? Were there 5,000? 307? This makes a huge difference.

And we should be careful to not fall into survivorship bias for there are hundreds, if not thousands, of actively managed funds that existed in 1994 that no longer exist today. Since you cannot invest retroactively, the shuttered funds are important in determining the percentage of funds that beat the market average (reverting to the bias that the S&P 500 fund is the relevant benchmark for all funds).

Stupid math tricks
But here's my question: Who says that 10-year performance is the definition of "long term" anyway? I know of very few people for whom 10 years is the entirety of an investment career, and as both Bogle and Burton Malkiel ascertain, not even 10-year performance is sufficient to determine whether a fund will truly outperform. In A Random Walk Down Wall Street, Malkiel notes that of the funds that were top 20 performers in the 1970s, only one, Fidelity Magellan (FUND: FMAGX  ) , remained in the top 20 in the 1980s. Nine of them were in the bottom 50% of all funds in terms of performance.

Long-term outperformance is what happens over a lifetime of investment returns. Fortunately, here we have some (imperfect) data to observe what has taken place over a longer period of time.

In an April 2004 speech, Bogle noted that in 1970 there were 355 mutual funds. Of these, more than 60% no longer exist. Of the remainder, 43 managed to beat the S&P 500's average annual return of 11.3%, only 23 of them clearly above a statistical threshold. That's an outperformance percentage of between 6.5% and 12.1% of all funds over the long term. Let's not quibble with the percentages and instead settle on this fact: Outperforming the passive index is hard due to the drag on net returns caused by expenses, loads, and taxes.

Problem three has to do with that last component mentioned above: taxes, and their compounding impact on a portfolio. Nathan notes that there are tax-advantaged funds, which is true and great news, but he also said that the tax disadvantage is only 0.63% for the average fund. These taxes are paid in real dollars, annually. As such, the impact on fund returns for each 0.63% is compounding. So, theoretically, if the average return for the S&P 500 was 11.3% over the last 34 years, ignoring everything else, the tax disadvantage would take the rate of return down to 10.67%. For a $10,000 portfolio funded in 1970, the values would be $380,921 vs. $314,063, a difference of $66,858. That's big money. Or perhaps I should say only $66,858.

I'm certain this will come off as a "besides that, how'd you like the show, Mrs. Lincoln" sort of comment, but I'm glad for the opportunity to revisit some of these conclusions. Please be aware of statistics, even mine. Heck, especially mine -- they're presented truthfully, but they are derived from John Bogle's presentation. Bogle has earned the benefit of the doubt, to be sure, but he is certainly and admittedly a tireless promoter of indexing. It's possible that the preponderance of funds in existence today will outperform every relevant index going forward, but that's a difficult inference to make given past performance and the ongoing drag of fees, taxes, and high turnover in many actively managed funds.

So to the question that Nathan's column raised, among many, the answer is no. We're not abandoning the index fund in any way, shape, or form. We don't consider them to be "investing for morons." In fact, we're thankful that they exist, and we remain in awe of their simplicity and ability to allow investors to participate in the gains of commerce without ever learning the difference between a credit and a debit.

Fool on!

For great mutual fund ideas (yeah, they exist), try afree trial of Shannon Zimmerman's Motley Fool Champion Funds today.

Bill Mannneeds to launder his karma. He owns shares of Berkshire Hathaway. The Motley Fool isFools writing for Fools.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 08, 2010, at 11:12 AM, RegenAssociates wrote:

    Dalbar the Federal Reserve and Dr. Krugman Report Zero Wealth Creation For the Last 20 Years

    Why is there such a disparity between the gross returns of 7- 8% for the average investor and the net real returns of 1- 2% after fees, expenses, taxes and inflation confirmed by Dalbar, the FRB and by Dr. Paul Krugman for the last 20 years.

    Rather than bemoan this sad state of affairs and since it is unrealistic to expect expenses, taxes and inflation to be drastically reduced any time soon as some have advocated, a better approach was to find out what controllable factor(s) are responsible for this corrosive drag on performance.

    Many fees and expenses are controllable; the trick is to restrict selections to “no-load/no-fee” funds that also beat the S&P 500. These funds incur minimal additional acquisition costs giving the fund investor an initial, but limited, boost in returns.

    Why should the average investor be subjected to a 95% chance of zero wealth creation over a lifetime of employment?

    Why Do Current Methods Of Fund Selection Deny Millions of Investors Access To Wealth Creation?

    Most investigators and writers deny the role of past performance in indicating persistency. Instead they favor factors as: manager’s tenure, low or no loads, low cost ratios, low turnover … to improve persistency. Our research since 1994 supports the view that performance accounts for at least 95% of persistency while non- performance factors account for no more than 5%. So if investigators turn their backs on performance then 95% of the solution to the persistency problem is being discarded out of hand. Using 5% of the solution to a problem no matter how cleverly crafted is like trying to climb Mt. Everest without oxygen. This is the precisely the current situation.

    After analyzing the patterns of hundred of millions of data cells since 1994, the culprit was found. It was "adverse selection", which is the systematic selection of more losers than winners usually on a 75:25 ratio basis, caused by an overwhelming number of losers. By reversing these odds, mathematically, many times more winners than losers can be picked.

    Consider a container of 10,000 marbles. Each marble represents a fund. Each fund has an equal chance of being selected. Suppose 2,500 funds are winners (funds that beat the S&P 500) and 7,500 funds are losers (funds that do not beat the S&P 500). With millions of selection (investor) trials, there will always be a 3 times greater chance of selecting losers than winners in the precise, predictable 3 to 1 ratio.

    Unless the 7,500 losers can be objectively removed from the container, the laws of probability tell us there will always be a 3 times greater chance of selecting loser funds than winners unless a science-based intervention takes place to reverse the "adverse selection" process.

    A winner is defined as a fund whose performance consistently outperforms the Standard & Poor’s 500 Stock Index over time.

    A loser is defined as a fund whose performance consistently under performs the Standard & Poor’s 500 Stock Index over time.

    There is a widely held belief among financial writers and scholars that past performance cannot guarantee or even indicate future results. This statement is required by the SEC to appear in every fund prospectus which gives it authority and credence. Yet in reviewing the literature for the past 6 decades not one well-designed study has appeared to prove past performance does "not" indicate future results.

    Let’s take a look at some of the underlying principles at issue here.

    First, there is the concept of "repeatability” or “persistency”. This is the likelihood that last year’s benchmark returns will repeat in the following time frame. Surprisingly, there is no general agreement among investigators concerning persistency. There is some spotty agreement that a 1, 2, 3, 4 year benchmark beating returns will repeat in years 2-5 despite the fact that 4-5% of funds do not survive each year. This is the so-called” the survivorship bias".

    In studying persistency, the effect of the survivorship bias has lately been softened, as it should, by some investigators. However, limiting selections to funds with 10, 15, or 20 years of history would eliminate the bias but impose the much more severe penalty of depriving investors access to many superior performing funds with lesser years of history.

    Technical knit-picking aside, isn’t it time the financial services industry stopped relying on unverified anecdotal information as a foundation for investment selections and begin using solid, proven scientific principles to help fulfill their trusted mission of helping millions of investors create wealth?

    Arthur Regen

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