An index fund is like a mutual fund in that it takes your investment dollars and spreads them out over multiple companies. Where a mutual fund will hire an “expert,” or a team of them, to pick specific companies to invest your money in, an index fund will do nothing more than invest your money equally across the whole market it is tracking. There are now index funds that will spread your investment dollars out across the entire world market or ones that will follow a certain stock exchange such as the NYSE, or the TSX. In other words, an index fund is a way to lock in your investment return at exactly the market average minus relatively small investment fees.
So just how good are these investment experts?
It initially appears ridiculous to believe that the vast majority of investment experts that work in Toronto and New York cannot do better than the market average; however, the statistics don’t lie. A recent study that appeared in the New York Times looked at 452 domestic mutual funds (taken from the Morningstar database) and their performance over the last 20 years. When compared to the Standard & Poor 500-stock index (more commonly known as the S&P 500), only 13 of these mutual funds beat the average returns of the index once their fees and tax disadvantages were taken into consideration. Those numbers are worth repeating: only 13 out of 452!
When did the definition of expert become below average?
There are a few factors responsible for this eye-popping statistic. One of the primary reasons many mutual funds do poorly is that their managers are extremely well-paid and are slaves to the most recent quarterly reports. The tried-and-true method for being able to cash huge paycheques for as long as possible is to simply try and mimic the index itself. If investment managers follow this strategy, they know that they will never have a period of time where they are too far below the average, and consequently, they will get to keep their jobs and their yachts. The next question one might ask is, “If so many managers are just trying to be average, why do mutual funds almost always return less investment income to investors than index funds do?” That answer is actually fairly straightforward, it’s a little thing called management fees. You see those yachts owned by Wall Street types which have been paid for with the dollars you invested in their mutual fund, and the subsequent returns they produced. There are all kinds of different fee structures, but 2% is fairly average in the USA, and some hedge funds with big-name managers charge well over 10%. Canada actually has the absolute highest mutual fund management fees in the world – yay, we’re number one! (Y&T’s note: HA, we’re finally #1 in something! No more underdog status!) So to recap, if most managers are simply aiming to get average results, and then charging you 2%+ to do just that, then, of course, they are going to give investors a much lower (2% a year makes a huge difference over long-term investing periods) rate of return than they otherwise would have gotten.
The other consideration this study focused on was the tax inefficiency associated with many of these mutual funds. Without going into too much excruciatingly boring detail, it is generally accepted that because stocks are being bought and sold constantly within mutual funds, there are all kinds of taxes and expenses incurred that wouldn’t be under most index investing plans. When your returns are constantly being limited because of fees and taxes, they cannot compound over time, and like Einstein says, “The most powerful force in the universe is compound interest.” That’s from the guy that created the atomic bomb! While the study concedes that owning mutual funds within a tax-advantaged account would have allowed a few more funds to slip into the “beat the index” category, the overall results would be very similar. The article goes on to state that it would be nearly impossible to predict which funds would beat the index ahead of time, so it is effectively useless to try using past results.
Efficient market hypothesis
The whole idea of index investing springs from something called the Efficient Market Hypothesis. What this theory basically claims is that the market is perfectly efficient. This means that if you invest for long enough and make enough trades you are almost guaranteed to return average results. It takes the whole idea of a competitive market to its logical conclusion: whatever the price of a company currently is, that is almost exactly what it is probably worth. For investors, the logical conclusion is that you stand almost no hope of “beating the market” long-term. If you can’t control what the market will return, the only thing left to control is the fees you pay; therefore, logic dictates that those who pay the lowest fees will come out ahead over time, and probably sooner rather than later.
Criticism of index investing
There are definitely some holes in the Efficient Market Hypothesis. Anyone who has looked at the stock markets over the last five years can tell you that there is no way they are perfectly logical. Now more than ever, markets can go soaring or fall through the basement due to a rumour, or a slightly lower-than-expected quarterly report. Many index investing converts have modified the theory to claim that while short-term markets may fluctuate illogically, in the long-term stock prices will average out because market fundamentals will ultimately bring a stock back to where it is supposed to be. Another relevant criticism is that the more people that are out there index investing, the less rational the market will become by definition. What supposedly makes the market completely efficient is the fact that there are people out there pouring over every little press release and balance sheet to determine the true value of companies. If people stop doing that, then the market ceases to be perfectly efficient. Finally, studies show that while index investors almost always do better over the long term, talented traders (the guys who run hedge funds) do substantially better in range-bound markets where the overall index stays more-or-less the same, but certain sectors or stocks will go up or down considerably. Most people believe this will describe North American and European markets for the next few years.
Is index investing for you?
No matter what study you look at, or what statistics someone will try to show you, there is little doubt that the average investor would be far better off in index funds than in mutual funds or picking their own stocks. Banks and investment managers will pull out all the convincing lingo and hard sales pitches they have in their arsenal to get you to invest in one of their house mutual funds that will funnel 2-3% of your money into their coffers. It doesn’t take a genius to figure out that if a Canadian were to invest with the popular TD E-series of index funds (note: I receive no compensation from TD, or any other bank, these are just the lowest-fee index funds in Canada) with management fees of .3%-.5%, they will be much better off than with an average mutual fund that is returning the same amount (or less) and then taking 2%+ in management fees off the top.
That being said, there is substantial evidence out there that someone willing to do their homework and stay on top of their own investments can beat the index by picking their own stocks. There are mutual funds and hedge funds that routinely beat the index, but take out most of the profit in fees. If you can pick investments at their level, you will beat the market (keeping in mind that it is their job and they are likely obsessed with it). There is also a body of evidence that shows that when you only look at hedge funds, and mutual funds that deviate substantially from the usual companies (in other words, the mutual fund managers that are secretly just trying to cash cheques while matching the average), you can find one that will consistently beat the average for you. This is fairly controversial, and at best, difficult to do.
For most people, the bottom line is that they don’t want to look at their investment portfolio daily or worry about short-term market volatility. They should just focus on making sure their asset allocation is appropriate for their risk tolerance and investment window. Index investing is by far the easiest and best way of doing this. It isn’t sexy, and you won’t sound cutting-edge at the water cooler, but you will almost always win out in the long run!