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Why Invest in Index Funds?

The following is an adapted, excerpted chapter from the 2018 edition of my book Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less.

Pay less for a product or service, and you’ll have more money left over afterwards. Pretty straightforward, right? For some reason, many investors seem to think that this rule doesn’t apply to the field of investing. Big mistake.

Index Funds 101

A bit of background: Most mutual funds are run by people picking stocks or other investments that they think will earn above-average returns. Index funds, however, are passively managed. That is, they seek only to match (rather than beat) the performance of a given index.

For example, index funds could be used to track the performance of:

  • The entire U.S. stock market,
  • Certain sectors of the U.S. stock market (the pharmaceutical industry, for instance),
  • Various international stock markets,
  • The bond market of a given country, or
  • Just about anything else you can think of.

Most Actively Managed Funds Lose.

The goal of most actively managed funds is to earn a return greater than that of their respective indexes. For example, many actively managed U.S. stock funds seek to outperform the return of the U.S. stock market. After all, if an active fund doesn’t beat its index, then its investors would have been better off in an index fund that simply tracks the market’s return.

Interestingly, most investors actually would be better off in index funds. Why? Because — due to the high costs of active management — the majority of actively managed funds fail to outperform their respective indexes. In fact, according to a study done by Standard and Poors, for the ten-year period ending 6/30/2017:

  • Less than 15% of U.S. stock funds managed to outperform their respective indexes,
  • Less than 21% of international stock funds managed to outperform their respective indexes, and
  • Less than 23% of taxable bond funds managed to outperform their respective indexes.

Now, lest you think that this particular period was an anomaly, let me assure you: It wasn’t. Standard and Poors has been doing this study since 2002, and each of the studies has shown very similar results. Actively managed funds have failed in both up markets and down markets. They’ve failed in both domestic markets and international markets. And they’ve failed in both stock markets and bond markets.

Why Index Funds Win

The investments included in a given index are generally published openly, thereby making it easy for an index fund to track its respective index. (All the fund has to do is buy all of the stocks — or other investments — that are included in the index.) As you can imagine, implementing such a strategy can be done at a far lower cost than that charged by the average actively managed fund.

Common sense (and elementary school arithmetic) tells us that:

  • If the entire stock market earns, say, a 9% annual return over a given decade, and
  • The average dollar invested in the stock market incurs investment costs (such as brokerage commissions and mutual fund fees) of 1.5%,

…then the average dollar invested in the stock market over that year must have earned a net return of 7.5%.

Now, what if you had invested in an index fund that sought only to match the market’s return, while incurring minimal expenses of, say, 0.2%? You would have earned a return of 8.8%, and you would have come out ahead of most other investors.

It’s counterintuitive to think that by not attempting to outperform the market, an investor can actually come out above average. But it’s completely true. The math is indisputable. John Bogle (the founder of Vanguard and the creator of the first index fund) refers to this phenomenon as “The Relentless Rules of Humble Arithmetic.”

Why Not Pick a Hot Fund?

Naturally, many investors are inclined to ask, “Why not invest in an actively managed fund that does beat its index?” In short: because it’s hard — far harder than most would guess — to predict ahead of time which actively managed funds will be the top performers.

In addition to their “indices versus active” scorecards, Standard and Poors also puts out “persistence scorecards” from time to time. In the most recent one (published June 2017), they found that of the funds that had a top-quartile ranking for the five years ending March 2012, only 22.43% maintained a top-quartile ranking for the following five-year period. Pure randomness would suggest a repeat rate of 25%. In other words, picking funds based on superior past performance proved to be no better than picking randomly!

In another study, Morningstar’s Russel Kinnel looked at the usefulness of expense ratios and star ratings (which are based on past performance) at predicting future performance. Kinnel summarized his findings:

Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. […] Stars can be helpful, too, particularly in identifying funds that might be merged out of existence.

In other words, past performance can be useful for identifying future poor performers. (That is, the worst performing funds tend to continue to perform poorly, and they are often shut down by the fund company running them.) But if you’re looking to pick a future top performer, picking a low-cost fund is your best bet. And looking for low-cost funds naturally leads to the selection of index funds as likely top-performers.

Taxes Are Costs Too.

If you’re investing in a taxable account (as opposed to a 401(k) or IRA), index funds can help you not only to minimize costs, but to minimize taxes as well. With mutual funds, you pay taxes each year on your share of the capital gains realized within the fund’s portfolio.

Because most active fund managers buy and sell investments so rapidly, a large percentage of the gains end up being short-term capital gains. Because short-term capital gains are taxed at your ordinary income tax rate (as opposed to long-term capital gains, which are currently taxed at a maximum rate of 20%), you’ll end up paying more taxes with actively managed funds than you would with index funds, which typically hold their investments for longer periods of time.

Not All Index Funds Are Low-Cost.

Do not, however, invest in a fund simply because it’s an index fund. Some index funds actually charge expense ratios that are close to — or sometimes even above — those charged by actively managed funds. It’s a good idea to take the time to check a fund’s expense ratio and compare it to the expense ratios of other funds in the same category before investing in it.

When Index Funds Aren’t an Option

Unfortunately, in many investors’ primary retirement account — their 401(k) or 403(b) — they don’t have the option to select any low-cost index funds. If you find yourself in such a situation, my strategy for picking funds would be as follows:

  1. Determine your ideal overall asset allocation (that is, how much of your overall portfolio you want invested in U.S. stocks, how much in international stocks, and how much in bonds).
  2. Determine which of your fund options could be used for each piece of your asset allocation.
  3. Among those funds, choose the ones with the lowest expense ratios and the lowest portfolio turnover. (For funds in your 401(k) or 403(b) this information should be available in the plan documents.)

Simple Summary

  • Because of their low costs, index funds consistently outperform the majority of their actively managed competitors.
  • A fund’s past performance (even over extended periods) is not a reliable way to predict future performance.
  • Not all index funds are low-cost. Before investing in an index fund, take the time to compare its expense ratio to the expense ratios of other index funds in the same fund category.
  • If you don’t have access to low-cost index funds in your retirement plan at work, look for low-cost, low-turnover funds that fit your desired asset allocation.

The Cost (to an Index Fund) of Turnover in an Index

A reader writes in, asking:

“When stocks enter or leave an index, an index fund is forced to sell the leaving stocks and buy the entering ones. I have heard that this results in a cost to the index fund. Is this cost big enough to matter much?”

There are two types of costs imposed on an index fund when stocks move in or out of the index that the fund tracks: transaction costs and front-running costs.

Transaction costs are the brokerage costs and bid/ask spreads incurred by buying and selling shares of a stock.

Indexes themselves, unlike index funds, have no transaction costs. As such, transaction costs would show up in the form of “tracking error” (i.e., the amount by which an index fund trails the performance of its respective index). As it turns out though, most index funds from reputable providers (e.g., Vanguard, Fidelity) don’t often trail their indexes by amounts significantly more than their expense ratios. In other words, the total transaction costs for such funds are often sufficiently small that they typically don’t even make an observable impact on fund performance.

Given the above, and given that transaction costs from stocks entering/leaving the index are only a part of an index fund’s overall transaction costs, we can confidently conclude that the transaction costs specifically resulting from changes in the index must be very small.

The second type of costs, front-running costs, are the reduction in performance that results from other parties bidding up the price of a stock by buying shares after the announcement that the stock will be added to a given index but before index funds buy it. It’s difficult to estimate such costs because they don’t show up as tracking error, because such costs affect the performance of the index itself as well as the performance of index funds.

In the last decade, two studies estimated the cost of front-running to be in the 0.2-0.3% per year range for index funds that track the S&P 500. That would certainly be a significant cost over time. However, other parties have argued that the cost has likely declined (and will continue to decline) as front-running opportunities are largely eliminated due to the idea becoming so well known.

In addition, you’re largely unaffected by such costs if you stick to “total market” funds, because your fund would already hold such stocks well before the bidding up that happens when the stock is announced for inclusion in something like the S&P 500.

So in short, yes, costs are imposed on an index fund when stocks are added to or removed from the index that it tracks. However, such costs (both transaction costs and front-running costs) tend to be very small, especially for the most diversified index funds.

What’s the Maximum Expense Ratio Somebody Should Pay for a Mutual Fund?

A reader writes in, asking:

“As I try to select among the funds in my 401k plan, is there a limit to the high end of expense ratio that you suggest not going beyond?”

The maximum expense ratio that I would pay for a fund depends on the context. Specifically, it depends on the availability of a less expensive suitable substitute.

For example, consider an investor with a $100,000 portfolio, all of which is in her 401(k). She has decided that her ideal asset allocation would be:

  • 60% in US stocks,
  • 20% in international stocks, and
  • 20% in bonds.

And, in her 401(k), the lowest-cost investment options in each of those categories are:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

Our investor has a dilemma. She wants a 20% international stock allocation in her portfolio. But she would have to pay an extra 0.6% per year for that part of the portfolio in order to have such an allocation (rather than just allocating the entire stock part of the portfolio to the US stock index fund).

Frankly, if I were in that position, I wouldn’t pay the additional cost. I appreciate international diversification, but an avoidable cost of 0.6% per year is a high hurdle for the diversification to overcome in terms of added value.

But what if our investor’s lowest-cost investment options were as follows?

  • An actively managed US stock fund, with an expense ratio of 0.65%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, our hypothetical investor would now only be paying an additional 0.05% per year for her international allocation. The international fund’s cost hasn’t changed at all, but it has become quite a bit more attractive because the alternative (i.e., keeping the entire stock allocation in the US stock fund) has become more expensive.

Point being: The maximum expense ratio that it makes sense to pay depends on the cost and suitability of the nearest substitute. In our first scenario the 0.7% expense ratio was too high because there was a low-cost substitute (albeit an imperfect substitute). In the second scenario, the 0.7% expense ratio was not prohibitive, because there was no low-cost substitute.

What if There Are Multiple Accounts?

Let’s look at one more hypothetical scenario. Our investor still desires an allocation of 60% US stocks, 20% international stocks, and 20% bonds. And the options in her 401(k) are the same as in our first scenario above:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, however, her portfolio consists of $50,000 in her 401(k) and $50,000 in a Vanguard IRA. In this case, she has no reason whatsoever to pay the high cost of the international fund in her 401(k), because she could achieve her desired overall allocation by buying an international index fund/ETF in her IRA.

Again, the overall conclusion is that the maximum “acceptable” expense ratio for a fund varies based on the availability of less expensive suitable substitutes.

Why Don’t Vanguard’s Target Retirement and LifeStrategy Funds Own Admiral Shares?

One question I receive periodically is why the Target Retirement and LifeStrategy funds at Vanguard hold “Investor” shares of the underlying funds, rather than the less expensive “Admiral” shares. Emily Farrell, Head of U.S. Business PR at Vanguard, was kind enough to provide the answer.

—–

Piper: Why don’t the LifeStrategy and Target Retirement funds use Admiral shares as the underlying holdings?

Or, if there’s a concern about that being a way to “cheat” to get access to Admiral shares without meeting the requirements, why not have an Admiral share class for the LifeStrategy and Target Retirement Funds, with a higher minimum investment (i.e., a high enough figure such that a person investing that amount via an identical DIY allocation would qualify for Admiral shares of all or most of the underlying funds)?

Farrell: Vanguard is unable to offer multiple share classes on funds of funds due to the structure in which we operate, and the agreement we have with the SEC regarding multiple share classes. Our funds of funds have no direct costs — the costs are derived only from the ERs of the underlying funds. According to that agreement, we must be able to offer a differentiated cost advantage between share classes. (Therefore, because there is no direct cost associated with a fund of fund — it’s not possible for us to offer such an advantage).

As you may recall, we launched a suite of Institutional TRFs in 2015. Note, however, those are not share classes — they are an entirely new set of mutual funds.

Piper: Given that Vanguard can only have one share class of a fund-of-funds, how does Vanguard decide which share classes to hold within such funds? The “normal” (non-institutional) versions of the funds-of-funds each hold Investor shares of the underlying funds. Would Vanguard ever consider holding Admiral share classes in these funds?

And, for example, the Vanguard Institutional Target Retirement 2050 Fund (VTRLX) holds Institutional shares of one underlying fund, Admiral shares of another fund, and Investor shares of two funds. What’s the line of thinking there?

Farrell: It is largely based on the cost to serve the underlying shareholder of the TRF or LifeStrategy Fund. These funds tend to attract small balance accounts and IRAs, and the cost to serve is disproportionately higher than funds with large and diverse shareholders. In terms of looking into adding holding Admiral in the Investor suite of TRFs, in short, the answer is yes — we consistently review our products, product structures, and product line-ups. However, given the size of the average TRF account and our cost allocation methodologies, we would not expect a change from Investor Shares. Specific to the underlying holdings of the Institutional suite of TRFs, again, it is cost to service the funds and our cost allocation methodologies that dictate the share class utilized.

—–

So, to paraphrase, Vanguard’s position here is, “in a Target Retirement or LifeStrategy fund, we hold whichever share class (or share classes) result in an expense ratio that most closely reflects the cost to service the fund’s shareholders.” In hindsight, that feels sort of obvious, given Vanguard’s general “at cost” pricing philosophy.

8 Simple Portfolios with Fidelity Funds (and iShares ETFs)

A reader writes in, asking:

“Your page of 8 simple portfolios is great guidance for people who want a simple plan they can institute. I wondered whether that page could offer a list of Fidelity options for some of those portfolios…if they are up-to-snuff enough and low-cost enough.”

The idea of the original “8 simple portfolios” article was to provide a menu of several possible portfolios, sorted by complexity (i.e., a one-fund portfolio, two-fund portfolio, and so on). At the time, I listed Vanguard funds simply because they are my go-to company for index funds.

But, to be clear, Fidelity does have a perfectly good lineup of low-cost index funds. In addition, they offer commission-free trades on a number of iShares ETFs, which can also be used to build a low-cost, diversified, simple portfolio.

Before we get into the portfolios, let me answer a few questions first:

  • As with the previous article, in order to make comparisons easy, each of the portfolios is built using the same overall stock/bond allocation (70/30). There’s no particular reason that a 70/30 split was chosen over any other allocation. Investors with differing levels of risk tolerance would want to adjust as necessary to meet their needs.
  • Each of the portfolios uses a roughly 50/50 domestic/international allocation for the stocks, because that is what I used to use when I had a DIY portfolio. Such an allocation is not going to be a good fit for everybody. Again, adjust as necessary to match your risk tolerance.
  • I’m using the ticker symbols for the “Premium” share class for the Fidelity index funds, but the “Investor” share class versions are perfectly good options if you don’t meet the minimum investment requirement for the Premium versions.
  • With regard to tilting the portfolio toward small-cap stocks and/or value stocks: I have never done this with my own portfolio, but such tilts are one of the more compelling reasons to include several (i.e., more than three or four) funds, so I am assuming that that is the goal of the more complex allocations.

One-Fund Portfolio

I would caution against accidentally buying a “Fidelity Freedom Fund” rather than a “Fidelity Freedom Index Fund.” The non-indexed versions are quite a bit more expensive and include a whole list of bizarre allocations.

Two-Fund Portfolio

  • 70% iShares MSCI All Country World Index ETF (ACWI)
  • 30% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF  (AGG)

Three-Fund Portfolio

  • 35% Fidelity Total Market Index Fund (FSTVX) or iShares Core S&P Total U.S. Stock Market ETF (ITOT)
  • 35% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 30% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)

Four-Fund Portfolio

  • 30% Fidelity Total Market Index Fund (FSTVX) or iShares Core S&P Total U.S. Stock Market ETF (ITOT)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 30% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 30% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)

Five-Fund Portfolio

  • 30% Fidelity Total Market Index Fund (FSTVX) or iShares Core S&P Total U.S. Stock Market ETF (ITOT)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 30% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Six-Fund Portfolio

  • 20% Fidelity 500 Index Fund (FUSVX) or iShares Core S&P 500 (IVV)
  • 10% iShares S&P Small-Cap 600 Value Index (IJS)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 30% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Seven-Fund Portfolio

  • 20% Fidelity 500 Index Fund (FUSVX) or iShares Core S&P 500 (IVV)
  • 10% iShares S&P Small-Cap 600 Value Index (IJS)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 20% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 10% iShares MSCI EAFE Small-Cap Index (SCZ)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Eight-Fund Portfolio

  • 20% Fidelity 500 Index Fund (FUSVX) or iShares Core S&P 500 (IVV)
  • 10% iShares S&P Small-Cap 600 Value Index (IJS)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 10% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 10% iShares MSCI EAFE Small-Cap Index (SCZ)
  • 10% iShares International Select Dividend (IDV)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Portfolio Turnover: How High is Too High?

A reader writes in, asking:

“When looking at a mutual fund at what point would you say it has a high turnover ratio? For example, I have a Mid-Cap value fund that has a 39% turnover ratio. Do you think this is too high? What are your thoughts on this?”

A turnover rate doesn’t mean anything without context.

For example, Vanguard’s Short-Term Treasury Index Fund — which is entirely passive — has a turnover rate of 211% according to Morningstar. That sounds super high, but for a short-term bond fund, it’s actually quite reasonable. The bonds in the portfolio mature frequently given their short-term nature, so the fund has no choice but to frequently buy new bonds.

Of course, stocks don’t “mature” like bonds do. But, at least for index funds, there is still going to be some degree of forced turnover for a fund when a stock it is holding moves out of the targeted category. And the more specific the targeted category, the greater that level of turnover.

For example, a mid-cap value index fund would have turnover whenever a holding becomes too large or too small to be classified as mid-cap. And it would also have (less common) turnover when a stock moves from being considered “value” to being considered “growth.”

And, therefore, a mid-cap blend fund (with no value/growth tilt) would generally have less turnover than a mid-cap value fund — because the mid-cap blend fund only has one source of forced turnover (i.e., one way in which stocks can move out of the targeted category) whereas the mid-cap value fund has two. Similarly, a value fund (with no specification as to market-cap) will also generally have less turnover than a mid-cap value fund. And a “total market” type of fund would have even less natural turnover, because companies only go out of the “total market” when they cease to exist as publicly traded companies.

And these expectations are in fact borne out if we look at the turnover rates for Vanguard index funds in these categories.

According to the Investment Company Institute, the asset-weighted portfolio turnover rate experienced by stock-fund investors for 2015 was 44%. (The fact that this is “asset weighted” means that larger funds count more heavily in the calculation than smaller funds.) So the turnover rate of 39% mentioned by the reader for his mid-cap value fund is below average for a stock fund, despite the fact that this fund is in a category that would typically lead to higher turnover than a more broadly diversified stock fund.

That said, the turnover rate is still roughly twice that of the Vanguard index fund in the same category.

In his book Bogle on Mutual Funds, John Bogle estimates that a fund’s costs from turnover will be in the rough ballpark of 1.2% x the reported annual turnover rate. So, for example, a fund with a 100% annual turnover rate will experience a “hidden” cost of approximately 1.2% per year. But that is of course just an estimate, and the actual costs will vary from one fund category to another.

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