The advantage of index funds is that they earn a market return for a minimal cost. That might not sound exciting to everyone but the alternative might be worse.
Why worse? Because beating the market is difficult. Recent studies show that most mutual fund managers fail to beat the market in any given year and underperform over time after fees.
This is not a new phenomenon either. Warren Buffett annually compared the performance of the four largest funds against the Dow in his partnership letters throughout the 1960s. He said, “The Dow as an investment competitor is no pushover, and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.”
Ben Graham did the same. He noted, across several decades, the difficulty investment funds had in outperforming. The earliest (that I could find) was in the 1940s. Graham suggested buying the 30 stocks in the Dow as an alternative to investment funds. He even half-joked in 1974 that if institutions kept underperforming they were better off building S&P 500 portfolios:
More and more institutions are likely to realize that they cannot expect better than market-average results from their equity portfolios unless they have the advantage of better-than-average financial and security analysts. Logically this should move some of the institutions towards accepting the S&P 500 results as the norm for expectable performance. In turn this might lead to using the S&P 500 or 425 lists as actual portfolios. If this proves true, clients may then find themselves questioning the standard fees most of them are paying financial institutions to handle these investments.
Both Buffett and Graham recognized the poor performance and even worked out some of the reasons why. Poor decisions by committee, desire to conform to what other funds do, over-diversification, and inertia were their thoughts. The three big ones are career risk, herd mentality, and, what Graham touched on, high fees.
Career Risk. Trying to beat the market, means investing differently from the market index. That guarantees the possibility of underperforming in any given year at some point. Seeing your portfolio underperform is hard to stomach for most people. It’s even harder when your job is on the line. Most people are incentivized to keep a lucrative, high-paying job. So fund managers take a conservative approach. They do their best to track the market index rather than deviate from it because deviating and falling short by a lot is career ending.
Herd Mentality. Much like career risk, it’s safer to do what other funds are doing, than risk being different and underperforming. It’s much easier to criticize a fund manager for owning a stock that drags down performance when no other fund owns it. But if every fund owns it, they all perform poorly and shareholders don’t leave for another fund. So fund managers do what similar mutual funds do to earn a return close to the average performance of those funds.
High Fees. Fund managers, analysts, traders, salespeople, and marketing cost big money — even more to turn a profit. Index funds don’t have that problem (except maybe marketing and profits). Higher fees cover the higher expenses and create a high hurdle that every fund manager must reach before their shareholders earn anything that year. If they want to match the market returns, they need to exceed it by the amount of their fees. So the higher the fees, the bigger the drag on performance.
Of course, index funds are not all sunshine and rainbows. There’s no guarantee of making money with an index fund. If the index it tracks has a bad year, the fund will too. Index funds will underperform the market return — however slightly — after fees over time. Unfortunately, index funds don’t solve the problem of human nature and behavioral mistakes. Though, the argument can be made that if you’re comfortable not beating the market, you’re less likely to make the bigger errors made by those attempting to do so.
That said, you do get the same benefits of mutual funds and more. Ease of use, automatic diversification, lower costs, a market return, and freedom from picking fund managers or stocks are built in. A good case can be made for using index funds in a sizable portion (if not all) of your portfolio. The experts tend to agree.
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In the fund industry, the average manager lasts five years, and the average investor owns four funds, so that’s four managers in the first five years, eight managers after ten years, sixteen after twenty years, and fifty-two over the entire sixty-five years. What is the possibility that fifty-two managers, coming and going, cleaning out their portfolios time after time, could with remote conceivability do as well as the index? The return you get from holding the market portfolio over sixty-five years—even a modest return—demonstrates the “miracle of compounding returns,” and the tremendous impact the cost of active management makes is “the tyranny of compounding costs.” The way mathematics works, this tyranny absolutely overwhelms the miracle of compounding returns; to wit, over an investment lifetime the active equity fund investor captures about 20 percent of the return available simply by holding an all-market index fund. — John Bogle
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I think index funds ought to constitute, just from the broad standpoint of prudence, a significant portion of one’s assets in equities. Because you know, the evidence is that over any substantial period of time – ten years, 15 years, 20 years – the odds that you will get a money manager who can outperform that period of time are about one in four.
So unless you’re very lucky, or extremely skillful in the selection of managers, you’re going to have a much better experience by going with the index fund. — Bill Miller
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It is very hard to underperform even if you’re working at it, which actually makes the case it’s hard to outperform when you’re working at it. I think the markets are extraordinarily efficient. And if you don’t have the time and energy to read up and study the markets and figure out which money managers to hire, it makes sense to stay in an index and pay the low fees, and you’ll do fine. — John Rogers
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I’d say as a general rule put it in index funds, there are even growth stock index funds now. I don’t see why small investors should horse around with money managers. They cost. They’re more expensive than index funds, and there’s no evidence that they do as well over a period of time. — Robert Wilson
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I like to put things into the context of Sharpe’s principle — that active investing is a zero sum game on net. For liquid asset classes like US bonds and stocks, for instance, this means that everybody who is active, or not indexing, are collectively a big index fund, on average. That big actively-traded “index fund” is being managed, so it’s also paying costs. So, a couple of percent is being drained out of that pool, compared with the guys who are paying very low amounts for passive indexing. So, these active investors collectively have a couple percent disadvantage. So, all the institutions that are battling for an edge in those liquid asset classes aren’t going to get alpha collectively. They should just index those parts of the portfolio, in my opinion. — Ed Thorp
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To beat the market is not easy. In addition to a good investment manager, the investor needs perspective, patience, and courage – qualities that do not abound in today’s intensely competitive world. For many investors, institutional and individual, an index fund may well be the best kind of common stock investment program. — Robert Kirby
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One thing I say to people is if you really don’t think that you can add value—and most people can’t—then I think your base investment case should be a passive product with a low cost. — Lou Simpson
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Standard & Poor’s uses a selection methodology that has nothing to do with value, growth or anything else. It just has to do with we’re going to have 500 stocks that are tradable, they’re liquid, they’re profitable, they have decent balance sheets, and they’re representative of their industry, and they’re probably diversified.
And that beats most people most of the time. And the reason it does, is not because it’s esoteric, but because that portfolio which is diversified, is just allowed to evolve.
The S&P doesn’t make a prediction and say “We think the economy’s going to slow, so we want to have more defensive stocks” or “We think that oil’s going up,” or “We think there’s a commodity boom, we want to have more commodity stocks.”
They just let the portfolio evolve over time. And because the world is largely unpredictable, a diversified portfolio that’s well representative of the U.S. economy (or the global economy for that matter), which is just allowed to evolve, is likely to do better than the average professional. — Bill Miller
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Individuals faced with all the complexities — and natural misunderstandings — of investment management almost always will be better off taking the “plain vanilla” approach to investing in target date, low-cost index funds. If they don’t, the sad reality is there are lots of really clever, charming people who know how to skin them alive with high-fee products that sound wonderful but are not good for them. — Charles Ellis
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The indexes have caused just absolute agony among the intelligent investment professionals because basically 95% of the people have almost no chance of beating it over time and yet all the people expect, if they have some money, they can hire somebody who will let them beat the indexes. — Charlie Munger
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The notion of the public at large owning index funds is a perfectly reasonable thing to do. I think it is very difficult to understand who the good managers are and what makes them good. I think about this a lot as it relates to my partners and people in other firms. It’s hard, and people need help, and the idea of using index funds is perfectly reasonable for getting an experience that is the market experience.
And the market experience, generally speaking over the past 100 years in the U.S., is high single digits, low double-digits compounded annually in income and stocks. That is over the long term, higher than any other asset class. — Chuck Akre
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The most important difference, in terms of categories of investors, is between those who can make high-quality active management decisions and those who can’t…
Almost everybody belongs on the passive end of the continuum. A very few belong on the active end. But the unfortunate fact is that an overwhelming number of investors find themselves betwixt and between. In that in-between place, people end up paying high fees whether to a mutual fund or a stockbroker or another agent. And they end up with disappointing net returns. — David Swensen
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There is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow-Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did. — Ben Graham
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You know, people say there’s no point in comparing things with the averages because you don’t buy the averages. And I’ve always added: Why not? There’s no particular reason why a person couldn’t buy 10 shares or 100 shares of all the stocks in the Dow-Jones averages and actually get their results. People don’t do it, for one reason or another, but there’s nothing impossible or unsound about it. — Ben Graham
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Investing is a funny business. It’s really easy to be average. Just buy an index fund. It’s really hard to be above average. — Howard Marks
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On average, the average large-stock fund manager produces average returns before fees and below-average returns after fees. So compared with after-fee returns, an index fund is superior. — Howard Marks
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In the real world, identifying managers with alpha is a mushy business. All alphas are variable and establishing statistical significance is impossible because none of us live long enough or, at least, the circumstances that produced alphas in one environment may fail to produce alphas in a different environment. — Peter Bernstein
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I think the…most important reason why the investor should not be led to emphasize his selection of individual stocks, and to neglect the general level of the stock market is the fact that there is no indication that the investor can do better than the market averages by making his own selections or by taking expert advice. The outstanding support for that pessimistic statement is found in the record of the investment funds, which represent a combination of about the best financial brains in the country, and a tremendous expenditure, of money, time, end carefully directed effort. The record shows that the funds have had great difficulty as a whole in equaling the performance of the 30 stocks in the Dow Jones Averages or the 500 Standard & Poor’s index. — Ben Graham
Related Reading:
Wise Words on Risk Management
Wise Words on Investing Mistakes