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Easy Money
By Jonathan D. Pond, January & February 2007
Index funds provide a simpler, safer way to reap the big returns that stocks offer long-term investors
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A new study has proved again an overlooked truth of investing: you don’t have to be a pro to make money in the market. To the contrary, while most mutual funds lure investors with the prospect of above-average returns, a growing mountain of evidence shows that the vast majority of funds that handpick stocks just don’t deliver over time. Actively betting on where stocks are headed can actually hurt performance. Index funds—mutual funds that passively mirror the performance of a specific index, such as the Standard & Poor’s 500—often prove to be the better bet.
Consider the latest batch of figures. Reporting in October on the recently ended third quarter, investment monitor Standard & Poor’s found that more than half of actively managed funds—portfolios selected to outperform the market—failed to beat their benchmark index, the measure of average gains or losses in their segment of the market.
The story was the same when S&P looked back one year, three years, and five years. For mutual funds that choose among large-capitalization stocks—the big companies tracked by the S&P 500—seven in ten had below-average returns during the past five years. Among actively managed funds investing in midsize and small companies, eight in ten were laggards. With international stock funds, almost two thirds fell short of their benchmark. Index funds beat them time and again.
If you are in the market for the thrill of the big payoff—the chance to make a killing—and you can live with the odds being stacked against you, read no further. Index funds are dull by definition, at best brainless beauties that rise when the market rises, and at worst, when the market tanks, equally brainless beasts. Average return is what they deliver, and variations among them mostly result from differences in the fees they charge.
If, on the other hand, you are counting on the healthy returns that buy-and-hold investing offers to help carry you safely to and through retirement—a retirement spent pursuing your passions rather than watching the stock ticker—then indexing deserves a serious look. Here’s why.
Index funds are cheap Low-cost mutual funds are always a good idea. The more a mutual fund charges, the smaller your return. One reason index funds have grown in popularity—assets in index funds have almost tripled since 2000—is that most don’t cost much, as well they shouldn’t. Being passively managed, with no stocks to research and no strategy to conceive or apply, index funds have few employees or costs to pay.
A good example: the granddaddy of them all, the Vanguard 500 Index Fund, charges just 0.18 percent a year for replicating the return of the S&P 500. That’s one eighth the average mutual fund’s expense fee.
And for those of you with taxable accounts, index funds provide additional savings. Since these funds generally don’t do a lot of buying and selling of shares they hold, the taxes on capital gains are minimal.
Index funds mean less stress Putting money in a mix of stocks and bonds—and keeping it there—is essential for anyone with savings to build or protect. Typically when stocks have a down year, bonds are up, and vice versa. No matter how impatient an investor you are, sticking with a well-diversified portfolio is the best way to grow your money; no matter how cautious you are, proper asset allocation is the way to stop inflation from eating away at it.
More than two thirds of the time, the unthinking market ate the so-called experts for breakfast.
The problem with stocks and bonds, though, is that they tempt investors to try to time the market—that is, to jump in and out of investments in an attempt to buy low and sell high. These efforts to beat the market tend to hurt returns, as Dalbar’s annual Quantitative Analysis of Investor Behavior has shown for 13 years. Not surprisingly, individual investors aren’t any better at predicting market movement than the professionals.
Index funds don’t shield you from the market’s ups and downs, but when used to build a diversified portfolio, they make it less harrowing to buy and hold your investments. You never have to worry that your funds will suffer losses far in excess of the average because, as we’ve said, index funds are the average. When you’re tempted to shift money from a lagging sector to a recent winner, try to remind yourself of the lesson the market is always teaching: no one can predict the future.
Average return is darn good Okay, we know what you’re thinking: it’s not as if active management never earns a better return (after fees and taxes) than investors get from an index fund. Hundreds of wily pros do beat the index and are crowned as geniuses for their achievement. But can you reliably spot future winners?
You read above about how poorly most funds did in the past five years. So let’s look at ten years of returns for actively managed funds. Take large-capitalization funds again, a huge and popular category: 30 percent beat the index. Mid-caps? 10 percent. Small-caps? 32 percent. International funds? 33 percent.
In short, more than two thirds of the time, the unthinking market ate the so-called experts for breakfast.
Investors’ biggest heroes were among the fallen. For example, Legg Mason Value Trust Fund is still in the top 3 percent of its category over ten years, but if you bought in last year, it put you in the bottom 2 percent, and for the past three years it’s been in the bottom 12 percent. Similarly, Clipper Fund, another large-cap buyer, is among the top 6 percent over ten years and at the very bottom for the past three years.
An average return starts to look pretty good under these circumstances, and it is. Rather than relying on stock market geniuses to guide your investments, go with the inherent genius of the market itself: its general tendency is to rise and rise, and at a pace that outstrips inflation. Somehow this long-standing habit of growth can get lost in the scramble for the “best” mutual fund.
Selection is a snap With almost 18,000 actively managed funds, sorting them out can be overwhelming. Though there are now more than 600 index funds, the choice is easier: it comes down to picking those funds that give you instant diversification by tracking the broadest indexes. The biggest, broadest, most useful benchmarks are these:
- The Wilshire 5000 Index comprises almost all U.S. stocks traded on major exchanges. Funds based on this index are often called “total stock market” funds.
- Standard & Poor’s 500 Stock Index is one that newscasters often cite when they explain how stocks performed for the day. (Another, the Dow Jones Industrial Average, measures only 30 stocks.)
- The Russell 2000 Index selects the smallest 2,000 of the 3,000 largest U.S. companies commonly traded, making it a benchmark for small-company (also known as small-capitalization) index funds.
- The MSCI EAFE Index is a mouthful that stands for Morgan Stanley Capital International Europe, Australasia, and Far East Index. This mega-index comprises 21 country indexes, representing most of the developed markets overseas.
- The Lehman Brothers Aggregate Bond Index includes U.S. government, corporate, and mortgage-backed bonds. Most “total bond market” funds are based on this.
You can further simplify your selection by ruling out classes of funds that play on the index fund concept, such as “enhanced” index funds—these are active managers’ attempts to borrow the credibility of index funds while still picking some stocks—or “computerized” funds, which dispense with managers’ intangible judgments (those not based on numbers) but are still a form of active stock-picking. Also, most buy-and-hold investors needn’t bother with exchange-traded funds, index funds that trade like stocks, or specialized index funds that mirror a thin slice of the market. These funds are options for sophisticated investors who have a conviction about, say, the semiconductor industry, small Japanese companies, or other tiny segments. They don’t help you diversify, and the more selective an index, the more volatile its price is likely to be.
A simple and completely satisfactory portfolio can be built with just four index funds (see All-Index Portfolio), or, if that isn’t easy enough, there are some “funds of funds” that streamline things even more. Among the newest of these are so-called lifestyle funds, which allow you to choose among aggressive, moderate, and conservative mixes of stock and bond funds. Lifestyle funds automatically rebalance your investments periodically. (Be aware, however, that not every lifestyle fund is based on index funds. Some combine index funds, actively managed funds, and individual stocks and bonds.)
Regardless of which index funds you choose, first check performance: poor performance relative to similar funds usually means fees are higher, eroding returns. For guidance, check out one of the many mutual fund screeners online; unlike most, the screener at www.reuters.com lets you select specifically for index funds.
While there are no absolutes when the subject is market performance—the past really is no guarantee of future return—when looking at spans of a decade or more, stocks tend to gain in value, with the S&P 500 Index and its predecessors returning on average about 10 percent a year. Index funds take advantage of this, by doing whatever the market does. In this case following the crowd is the right way to go.
Jonathan D. Pond is the author of You Can Do It! The Boomer’s Guide to a Great Retirement (Collins, November 2006). His public television special of the same title will air on some PBS affiliates in December 2006 and March 2007.
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