Investing in Index Funds vs. Managed Mutual Funds

stock market index fundOne of the great debates in the investment world centers on whether mutual fund managers, in the aggregate, add any value for investors. Since Vanguard introduced the first index fund in the 1970s, skeptics and critics of the financial services industry have argued that professional money managers have failed to earn their keep. Taking all of them together, they simply don’t do any better than a random selection of securities in any given market or investment style.

Nonsense, argue investment companies. There are many managers who have demonstrated they can outperform a random selection of securities, even after subtracting their fees – you just need to know how to identify them. Furthermore, an active manager can provide benefits that a random basket of securities can’t: An active manager can hold more cash when things look ugly, or sidestep some bad news at a company by selling before the whole thing collapses. In contrast, indexers have to ride the bus off the cliff.

Who’s right? Well, if you have to ask, then it’s time to go back to the basics and look at how mutual funds  – including index funds – are designed and built. You must also examine some of the key metrics.

As with so many aspects of investing, context counts, and there is frequently a time and a place for both approaches.

What Is a Mutual Fund?

A mutual fund is simply an arrangement in which a group of investors pool their money together and hire a professional money manager to buy and sell securities on their behalf. The typical arrangement is for the money manager (or his company) to take an investment fee out of the assets of the fund each year – typically between 0.5% and 1.5%. It is referred to as an expense ratio, and comes directly out of your account as a proportion of your assets.

The investment company takes this money and uses it to take care of overhead, office expenses, and marketing, and to pay a custodian to handle transactions. The money also pays a salary to the fund manager and a team of analysts that helps the fund manager pick and choose stocks, bonds, and other securities to buy and sell. When you have a manager – or team of managers – that actively buys and sells selected securities in order to maximize return, minimize risk, or both, that approach is called active management.

But what if you didn’t need to pay a team of analysts to sit around all day and analyze securities? Could you pay a lower expense ratio? It turns out you can, via a special kind of mutual fund called an index fund.

mutual funds

 

What Is an Index Fund?

Index funds are still mutual funds, arrangements in which you pool your money with other investors. And you still have an investment company that handles your transactions. The difference is that the investment company isn’t trying to pay a fund manager and a team of analysts to try to cherry-pick stocks and bonds. Instead, the fund cuts out the middlemen, saves the investors their salaries, and just buys everything in the particular index it aims to replicate. This index could track stocks, bonds, or REITs, for example.

What Is an Index?

An index is an un-managed collection of securities designed to reflect the properties, returns, and risk parameters of a specific segment of the market. An index is a theoretical construct: You can’t buy shares directly in an index, but you can buy shares of the companies that are included in the index.

For example, the most widely known index is probably the Standard & Poor’s 500 index of  large-cap stocks. This index is simply the largest 500 U.S. companies traded on the New York Stock Exchange, as measured by their market capitalization, or the total value of all their stock.

The index itself is weighted by market capitalization, meaning the index includes more shares of larger companies. Larger companies therefore have a bigger effect on index fund returns than smaller companies.

How does it work? It’s simple: An investment company starts an index fund and wants the fund to track the S&P 500. So they raise money, and then use the money to buy an equal percentage share of every company in the index. This share is going to be small – there are a lot of other people who already own each company, so they will typically buy something like 0.001% of each company in the index. The investors don’t own the index directly, but they own shares in this fund, which theoretically will track the performance of the index very closely, minus the amount of their costs.

Note that there’s no role for the analyst here – and all the fund manager does is ensure that the fund holds the securities in the index at all times. He doesn’t try to beat the index; he just makes sure the portfolio matches the index as closely as possible. This approach is called passive management.

Common Indexes

Investors, of course, aren’t limited to the S&P 500 index for their index investing. There are actually hundreds of indexes out there to choose from, and many investors use them in combination with one another.

Other commonly used indexes include the following:

  • The Russell 2000 tracks U.S. small-cap stocks.
  • The Wilshire 5000attempts to track the entire universe of stocks publicly traded on the NYSE.
  • MSCI EAFEtracks the largest companies in the European markets.
  • MSCI Emerging Markettracks the stock markets in various emerging economies, such as in Southeast Asia, Africa, South America, and Central America.
  • Barclays Capital Aggregate Bond Index tracks the universe of publicly traded bonds, including treasuries, corporates, and high-yield bonds.
  • NASDAQ 100is an index of the largest 100 companies whose shares are traded on the NASDAQ. This index is also a large-cap index, like the S&P 500, but is much more technology heavy.
  • Nikkei 225is an index that tracks the largest Japanese companies.
  • MSCI U.S. REIT Index tracks the performance of the largest publicly traded real estate investment trusts in the U.S.

There are indexes that track nearly every country in the world, most regions, and most asset classes. The U.S. market represents a little less than half of the entire market value of stocks traded all over the world. Many investors like to have substantial exposure to U.S. stocks, but also have a counterweight of exposure to European stocks, Asian stocks, emerging markets, REITs, and bonds. Some or all of this can be achieved through owning index funds.

investment planning

Does Index Investing Work?

Over the years, indexing has proven to be an effective strategy for a lot of retail investors. Here’s the theoretical underpinning behind the logic of indexing as a strategy:

Advantages

  1. Markets Are Efficient. The indexer basically believes that the market as a whole is very good at quickly pricing all the available information about a stock or a market into the market price (i.e. efficient market hypothesis). It is therefore almost impossible for a given money manager to outguess the market consistently over a long period of time.
  2. It Is Very Difficult to Identify Winning Fund Managers in Advance. Go back through time and look at the returns of the top fund managers every year. In the vast majority of cases, a fund manager will be flying high for a year or two, riding a market trend. But after the markets have run their course, another investment style becomes popular, and last year’s heroes are this year’s goats. The indexer believes it doesn’t pay to try to guess who will be this year’s best performing manager.
  3. Mutual Fund Managers Cannot Reliably Add Value Beyond Their Costs. The advocate of passive management reasons that in the aggregate, mutual fund managers and other institutional investors cannot reliably beat the market. Why? Because, collectively, they arethe market. They are therefore all but doomed to under-perform a well-constructed index by approximately the amount of their costs.
  4. Index Funds Have Lower Turnover. It costs money to churn – or excessively trade – securities in your portfolio. Mutual funds have to pay brokers and traders, and must also absorb the hidden costs of bid-ask spreads every time they trade. The bid-ask spread is the difference between what a stock exchange market maker pays for the stock and what they sell it for. Brokerage firms identify the overlap between what investors are willing to pay for a security and what investors are willing to sell a security for, and make part of their money by pocketing the difference. The more trading a fund does, the higher these costs. But index funds never have to trade, except when new securities are added to the index, or to buy or sell just enough to cover fund flows coming in and out as investors buy or sell. (Closed-end fund, or ETF, managers do not have this worry.)
  5. Index Funds Are Tax-Efficient. Index funds are normally tax-efficient, thanks to their low turnover. This is important because every time a mutual fund sells a holding at a profit, it must pass that profit on to its shareholders, who pay capital gains taxes on that profit. This isn’t relevant for funds held in retirement accounts, like an IRA or a 401k, but it’s a major consideration for mutual funds held outside of retirement accounts. For this reason, index funds are popular choices for use in taxable (non-retirement) accounts.

Performance

Because of these built-in structural advantages, one would expect index funds to routinely outperform the median performance of actively managed funds that invest in the same category. Index funds can’t beat the index, but because they approximate the returns of the index while minimizing expenses, the lower expenses should give index funds a noticeable advantage. We would not expect to find a low-cost index fund in the bottom half of the universe of mutual funds with a similar investment style for a long time.

So what do we find? Let’s look at the returns of the Vanguard 500, the original and one of the most commonly held index funds, which tracks the S&P 500. We’ll use the investor share class, which is the non-institutional variety and the fund that most investors can actually invest in.

1. Stock Funds
As of January 23, 2012, the Vanguard 500 fund is firmly in the top half of all large-cap blended style (balanced between growth and value style) that Morningstar tracks. This is true whether you look at the 10-year, 5-year, or 1-year track records, where the fund posts percentile rankings of 41, 33, 28, and 19 respectively. (With percentile rankings, low numbers are good and high numbers are bad. A “1″ means the fund is in the top 1%, while a “99″ means the fund is in the bottom 1%. Anything less than “50″ means the fund did better than the median.)

Does the strategy transfer to bonds? Let’s see:

2. Bond Funds
As of January 23, 2012, the Vanguard Total Bond Market Index, which now tracks the Barclays Capital Aggregate Bond Index, posted 10-year, 5-year, 3-year and 1-year trailing return percentiles of 44, 36, 83, and 15, respectively. For the most part, the fund has been successful in outperforming the median bond fund, though not as consistently as the S&P 500 tracking counterpart. In both cases, though, the managers have been pretty successful tracking their indexes, trailing them over the last 10 years by amounts roughly equal to their costs.

That’s about what you’d expect, since indexes, as theoretical constructs, have no costs. Only actual mutual funds have costs, and indexers simply seek to minimize those costs.

growing your investment

The Warren Buffett Counterargument

Warren Buffett, the chairman of Berkshire Hathaway and among the most successful value  investors, rejects the logic of efficient markets. It’s easy to see why: He made his fortune – and the fortunes of an awful lot of other people – by buying stocks at a discount to their intrinsic value. Very simply put, he looks for stocks that markets are pricing unfairly low, precisely because the efficient market theory doesn’t hold in every case, by a long shot. In his view, he’s been successful many times in finding stocks selling for 30%, 40%, or even 60% off of their true worth. “I’d be a bum on the street with a tin cup if markets were efficient!” he once told investors.

The downside to this approach to investing, of course, is that it takes a great deal of time and frequently leads to very narrow portfolios, which can mean more volatility. Not every investor can take the time to emulate the Buffett approach, even if they had his prodigious knowledge of accounting and business experience – which brings you back to picking a mutual fund and deciding if you want to pay a manager a percentage to pick securities for you, or if you want to keep the fee and invest it, rather than paying it to the manager.

For most people who don’t have the time and expertise to dig deeply into analysis and research, even Buffet recommends the indexing approach.

Final Word

Naturally, investment companies are ferociously defending their turf. They make a good deal of money from people who hire active managers. And some managers have been able to add value for investors over and above their costs in expense ratios and fees. In fact, active management proponents argue that it doesn’t make sense to compare index funds to the average fund because it’s possible to identify stronger managers up front. You can, for example, restrict your analysis to active fund managers that have a tenure of at least 5 or 10 years and lower expense ratios.

And the debate goes on. To determine which approach you prefer, start by assessing your needs and what you’re investing for. For example, will capital gains be an issue – will you be investing in or outside a retirement account? And are you prepared to research mutual fund managers to identify which might procure gains over and above their relative index?

Review the advantages to index investing above and see if they make sense to you. If you still can’t figure it out, invest in both and let experience be your guide.

(photo credit: Bigstock)

By Jason Van Steenwyk from MoneyCrashers.com

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