The Power of Index Mutual Funds

November 21, 2018

Investing, Stocks

“Shouldn’t growth investments grow?” thought a frustrated Moshe Samuels. For years, he had carefully selected high-potential mutual funds for his savings, choosing those that were well-rated and strong performers, but despite the funds’ dynamic names (“dynamic growth fund,” “strategic wealth fund”) his savings were barely growing. Even the investments chosen by a financial advisor had disappointed, doing well for a bit and then lagging. It was clear that he was doing something wrong.

What could Moshe do to improve his investment returns? Could he choose funds that would consistently match the terrific gains of the stock market?

Investment Traders Are Winners and Losers

There’s an expression that a six-foot man can drown in a river that’s an average of just two feet deep. Averages mask the realities of a variety of experiences, and in a year in which the stock market makes 10%, some investors make a lot more and some a lot less. Those who make more than the average (winners) do so at the expense of those who make less than the average (losers) by doing a better job of selling stocks that ended up falling to buy shares that would rise. Most investors, including Moshe’s mutual fund managers, want to be winners by outsmarting the losers, and spend a lot of money and effort trying to do so. This goal is a lot easier aimed at than reached.

The problem is that it’s not easy to find losers to trade against, and each manager’s effort cancels out the others’. (Think of two equally matched football teams playing against each other—there’s a lot of bruises with little scoring.) These active trader-investors have, as a group, had abysmal performance as they waste fortunes futilely trying to outsmart equally matched opponents. Of course, there are exceptions, winners who have tremendous track records over many years, but they are few and far between, and once identified as superstars they are already billionaires who won’t take your money to invest! Moshe keeps choosing funds that have had a brief winning streak, but it’s almost impossible for the winners to keep winning. Instead, all the fees he’s paying to the advisors and managers bring down his returns to well below average. There is another way, though.

Compound-investing with Index Funds

As far back as the 1970s, market experts noticed how active trader-investors were wasting their money trying to beat each other, and proposed a solution. Instead of trying to be winners and also risk being losers, investors should be compounders. Rather than trying to trade and beat each other continually, compounders invest in and hold onto the whole market. This strategy involves having an investment pool, called an index fund, buying proportionate shares of every public company (big pieces of large companies and small pieces of the small companies as per the index), and allowing their dividends and natural growth to compound over the long run.

By owning a sliver of the entire stock market, passive compounders are guaranteed to match its long-term growth. Some companies in the basket will do poorly, but because the passive compounder also always owns the Apples and Amazons, it all balances out. These index funds gained steam in the 1990s and today are beginning to dominate the investment world. Why is that? Because indexing has been proven to work! Moshe can easily get the outstanding long-term average returns of the stock market by becoming an index investor.

Index Funds: Low Fees Bring Big Gains

Vanguard, the pioneer and leader of index-fund investing, is now the world’s largest mutual-fund company with almost $4 trillion (!!) in assets under management. Much of the fantastic power of index funds stem from much lower operational costs, which can save investors as much 2–4% every year. Over time, these cost savings bring a tremendous advantage to index funds, and active trader funds can’t keep up over the long run.

The proof is in the pudding, and independent research confirms that the index compounders’ approach beats the overwhelming majority of active traders’. Index manager S&P tracks the data and, depending on the category (large stocks, small stocks, real estate stocks, etc.), 66–100% of active trader funds earned less than their index fund equivalent. Basically, the traders waste so much money trying to beat each other that they all lose!

Stick to Vanilla and You’ll Enjoy

In addition to having excellent performance records, index funds are very tax-efficient, easy to understand, and simple to use as part of a diversified portfolio. There is a straightforward caveat, which is to stick with the vanilla, low-fee index funds offered by major firms like Vanguard, Blackrock, Fidelity, or Schwab. To bolster their profit margins, some mutual fund companies have come out with “Frankenstein” index funds which may have high fees, be risk-laden through leverage, or follow a risky niche index (social media index fund stocks, or a Zimbabwe index fund). Technically, these are index funds, but they have strayed far from their originally intended use. But in general, index funds are the go-to investment for almost everybody, and even super trader-investors like Howard

Marks, David Swenson, and Warren Buffett recommend them to all but the largest investors who have many millions to invest. Until Moshe is that wealthy, he has a simple but powerful investment path to follow.

Almost Everyone Loves Index Funds

Warren Buffett, as noted a fan of low-cost index funds, estimated that they have and will save individual investors hundreds of billions in fees. Understandably, the Wall Street firms and brokers who are losing those vast sums in income hate these new streamlined investment options. To justify their consistent underperformance and ongoing fees, they use all types of arguments and marketing gimmicks, but to date, no one has credibly poked holes in the data and theory underlying indexing’s tremendous success. Most brokers who still sell high-fee active funds believe in them despite the evidence, but as the saying goes, “It is difficult to get a man to understand something when his salary depends on his not understanding it.”