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Index Fund Investing

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Index funds offer compelling advantages to investors in all markets where they are available. Index funds are the lowest cost, lowest risk, and lowest tax cost investment style available to investors. Importantly, these benefits translate into strong performance. Investors should confidently anticipate consistent top quartile performance over any reasonable time frame against the appropriate peer group of actively managed funds.

Each of these bold assertions has been widely debated and rigorously examined. The overwhelming evidence culled from both academia and real world experience supports the index fund approach. Indeed, indexing is the dominant proposition, and supplies the benchmark against which other approaches must be measured.

What is an index?

First, let’s define index and index funds. An index is an arbitrary collection of stocks or bonds selected to represent performance of a portion of a market or an asset class. So, we might say that domestic large company stocks, foreign small company stocks, and emerging market debt are separate market segments and build an index to track their performance. Or we might want to narrow our definition to domestic large company growth stocks, foreign small company value stocks, and Brady Bonds. The most useful indexes are widely accepted by investors and reported in the media.

Once we have defined our market segment or asset class, it’s simple to design an index to track the performance of our assets. Any reasonably bright undergraduate could whip out the specs in an afternoon.

The index becomes the benchmark for performance of the asset class. By extension, it becomes the benchmark to rate managers that trade within the asset class or market segment.

There are already thousands of indexes out there already that are used by investors to track portions of the world’s capital markets. For instance, we could probably find an index defining the performance of Chilean copper mining companies. Not all of them are very useful. Very few of them have their own index funds.

What is an index fund?

Once we have designed an index it’s child’s play to build an index fund to track that index. The fund simply buys all of the stocks or bonds included in the index at the appropriate weights specified by the index. Investors wishing to capture the performance of the index can do so by investing in this fund. Today, index funds are readily available to track the vast majority of the world’s investable assets.

What advantages do index funds offer investors?

Low Cost - Because index funds do not rely on research, or manager selection of individual issues, the cost of running them is a small fraction of traditional funds. For instance, the Vanguard S&P 500 index fund expense ratio is 0.18% per year, comparing favorably with other large company managed funds with average expense ratios of about 1.2%. These savings are passed on to investors in the form of higher returns.

Low Risk - Managed funds introduce an additional risk over and above market risk. The risk that the manager will underperform the index is substantial, running in the neighborhood of 75% to 80%. The average underperformance of professional managers is approximately 2% per year. Of course, a few managers always manage to beat the market during each time period. But, the best available evidence is that managers that appear to outperform the index have done so by pure chance or random drift, and that this out performance is not likely to persist into future performance.

Low tracking error - Index funds have low tracking error to their selected asset class, making them the best possible investments for asset allocation plans.

No style drift – Index funds have no style drift. You never wake up to find that your small company fund has invested in General Motors, or foreign stocks. What you see is what you get, again making index funds an ideal investment for asset allocation strategies.

Style drift is the enemy of the asset allocation process. It’s not possible for you to control the process with actively managed funds that drift aimlessly with the deranged and misguided whims of the manager. By the time you want to dump them, you may have a tax problem making the decision even more painful.

Index funds mean never having to face that particular problem again. You control the allocation, and you know you will get what you signed up for: a very close tracking to the market you selected.

Tax efficiency – When compared to an actively managed fund, index funds have negligible turnover. Low turnover is a very good thing indeed. Every time a fund buys or sells a stock, it creates a taxable event. The sum of all these events are passed onto the investor, who must then settle with Uncle Sam. Funds with high turnover will be forced to pay out almost all their gains as taxable dividends. So, even a fund with modest gains may be tax trouble. Taxes are the largest expense that investors face, so it’s essential that they do everything possible to control them. Any dollar that marches off the field to the IRS is gone forever, while deferred gains are not taxed, making the index fund buy and hold strategy even more attractive to taxpayers. The cumulative impact on terminal wealth is enormous.

Reliable performance – Index fund investors should confidently expect top quartile performance during any reasonable time period when compared to actively managed funds of the same portfolio characteristics.

Conclusion

Index funds are a natural choice for an intelligent investor seeking broad market exposure, minimum risk, minimum cost, and tax efficiency. When adjusted for common market factors such as size of company and BTM, (and in the case of international funds, country weightings) few managed funds beat index funds on a before tax basis, and the chance of beating them on an after tax basis is dismally small.

The single best way for investors to access all markets and market segments is through the appropriate index fund. Compared to actively managed funds of the same average size company, index funds will do well in both good and bad markets.

Said another way, indexing is a strategy that works in every market where it has been tested, and active management is a strategy that has failed in every market where it has been tested.