There are many good reasons to make market capitalization index funds the core of one’s investment portfolio. The main advantages that investors receive when they index a portfolio include reduced costs, increased diversification, style purity, asset allocation consistency, and, usually, the close tracking of the market rate of returns.
The simple mathematics of index investing
… it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. – William Sharpe
Nobel prize-winning economist William Sharpe in his article, The Arithmetic of Active Management, and John Bogle, in his Cost Matters Hypothesis (CMH), argue that the simple mathematics of investment costs are fundamental to the logic of index fund investing.
John Bogle lays out the CMH in his article, Vanguard’s Bogle responds to ‘parasite’ tag, in the August 15, 2013 edition of the Financial Times:
“The cost matters hypothesis is all that is needed to explain why indexing works: gross return in the market as a whole, minus the costs of obtaining that return, equals the net return investors actually receive.”
In today’s world investors can purchase low-cost index funds from such investment companies as Vanguard, Fidelity, Charles Schwab, Blackrock iShares, and SSgA.
The virtues of index fund investing become clearer with a long-term perspective on performance.
Low-cost index funds: lower costs lead to greater wealth accumulation
The index funds’ cost advantage over higher cost actively managed leads to a higher compounding of investment returns and a lowering of the corrosive compounding of investment costs. The table below shows the after-cost performance of a low-cost index fund, with total management and trading expenses of 0.20% per year, with the 2.50% annual management and trading costs of the average active fund.
The market return for an initial $10,000 investment in the stock market in 1980 and held to 2005 grew to a value of $179,200. The index fund grew to $170,200 compared to the average active fund’s growth to $98,200. The after inflation values come to $76,200 for the index fund; $40,600 for the average actively managed fund.
Active funds: survivorship and style consistency
An investor desiring to invest for the long-term faces a number of challenges when investing in mutual funds. A fund might disappear either by being shuttered or by a merger with another fund. A fund’s investment manager can leave the fund, either to pursue another management job, or by being dismissed for lackluster performance.
An investor wishing to hold small-cap value stocks might find that the fund has shifted its investment focus to mid-cap growth stocks (or vice versa), thus confounding the investor’s desired asset allocation decisions.
Standard and Poors examines mutual fund survivorship and style consistency. Over one-year periods, approximately 6% of all mutual funds cease to exist. The percentage of defunct funds rises to approximately 25% over five-year periods.
Standard and Poors also finds that nearly 20% of mutual funds shift styles over one-year periods, and approximately 50% shift styles over five years.
In a research paper, You’re Fired! New Evidence on Portfolio Manager Turnover (2011), researchers Leonard Kostovetsky and Jerold B. Warner examine mutual fund manager turnover.
From 1995 to 2009, the annual rate of mutual fund manager turnover averaged 18.7% of all mutual funds.
Standard and Poors Index versus Active reports
| Survivorship (All funds) | Survivorship (All funds) | Survivorship (All funds) |
| Period | 2002-2006 | 2009-2013 |
| 1 year | 6.37% | 6.45% |
| 3 years | 16.93% | 17.02% |
| 5 years | 23.02% | 26.07% |
| Style Consistency (All funds) | Style Consistency 2002-2006 | Style Consistency 2009-2013 |
| 1 year | 20.37% | 20.63% |
| 3 years | 41.00% | 38.77% |
| 5 years | 59.26% | 46.94% |
Index funds can mitigate these investment pitfalls.
- Broad-based index funds with established asset bases can be expected to survive for decade after decade (note that this is not necessarily true for narrow-based exchange-traded funds that are often liquidated if they do not attract assets.)
- Index funds are managed by investment management teams that concentrate on efficiently transacting the securities that are defined by the index. The loss of a manager has little effect on the management of the fund.
- An index fund is designed to track a given index. A US total market stock index will hold US stocks; an international stock index will hold international stocks. A large cap index fund will hold large cap stocks. This style consistency allows investors to target a desired asset allocation.
Performance probabilities
Rick Ferri, CFA, and Alex Benke, CFP, have examined the performance probabilities of various index portfolios versus actively managed portfolios in their award-winning white paper, The Case for Indexed Portfolios (see note).
The chart illustrates the study findings for the relative performance of US large-cap equity funds and the Vanguard total stock market index fund (1997 -2012).
Over this period, the index outperformed 77.1% of active funds. The results of the outperforming active funds is also skewed, with the median outperformance equaling +0.97% and the median underperformance equaling -2.01%.
The study also examines multiple asset class portfolios. These include:
- A three-fund portfolio (US equity, international equity, US taxable intermediate bonds
- A five-fund portfolio (US equity, international equity, REITS, US taxable intermediate bonds, US short-term treasury bonds)
- A ten-fund portfolio (US large-cap equity, US mid-cap equity, US small-cap equity, REITS, developed market equity, emerging market equity, US taxable intermediate bonds, US short-term treasury bonds, US inflation-indexed bonds, US intermediate tax-exempt bonds.
The results show indexed portfolios outperforming active fund performance, with skews in active fund performance.
| Portfolio | 2003 -2012 | Median performance loss | Median performance gain |
| Three-fund | 87.7% | -1.97% | 0.54% |
| Five-fund | 87.8% | -1.10% | 0.44% |
| Ten-fund | 90.0% | -0.93% | 0.29% |
Notes
- Source of data for accumulation chart and discussion comes from John Bogle, The Little Book of Common Sense Investing, pp. 44-46.
- In 2014, the Ferri/Benke white paper, The Case for Indexed Portfolios won first prize in the S&P Dow Jones Indices’ third annual SPIVA Awards program.
- The Ferri/Benke white paper portfolios hold 60/40 allocations: (click image to enlarge)
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- Three-fund portfolio
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- Five-fund portfolio
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- Ten-fund portfolio
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Next post in the investing basics series: Be mindful about taxes.
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