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Why index funds are rarely at the top…and why I like them anyway.

Neal of Wealth Pilgrim added a comment on a post earlier today asking the following:

One question – No Load Fund X newsletter -is one of the most consistent top performing newsletters – and it ranks ETF’s and Index funds against active funds. The ETF’s and Index funds aren’t always at the top. What say you my friend?

I’ve got a few thoughts on that. Let’s run through them one by one.

First thought: There’s no use considering any but the lowest cost index fund in a particular asset class. For instance, within S&P 500 index funds, it’s easy to determine which one is best. So we might as well eliminate every other S&P 500 index fund from any comparisons. (Only possible exception: We’re talking about a particular person’s 401k, in which they can only invest in one particular S&P 500 index fund.)

Takeaway: Many of the index funds mentioned on any particular list are suboptimal index funds (due to having higher costs than other index funds tracking the same index), so the fact that these index funds were beaten is rather meaningless, as there would have been no reason to invest in them anyway.

Second thought: Index funds are typically “fully invested” in their particular asset class. That is, they hold very little cash balances, whereas most actively managed funds hold a significant amount of their portfolio in cash at most times. As a result, over any period in which the market moves downward, active managers will benefit simply from having a greater percentage of their portfolio in cash. (Of course, the opposite benefit accrues to index funds during periods in which the market moves upward.)

Takeaway: During any bear market, active funds’ performance relative to index funds will be inflated, though not necessarily as a result of skill. Therefore, it’s hard to assign any predictive value to such outperformance.

Third thought: Depending upon how the list groups mutual funds, we may be comparing apples to oranges. For example, if all equity funds are grouped together, then index funds tracking the S&P 500 will look particularly good during periods in which large cap stocks outperform small cap stocks, and particularly bad during periods in which the opposite happens.

Takeaway: In a comparison that includes all equity funds, it’s really only meaningful to include index funds that track the entire market rather than the S&P. Otherwise we’re going to end up drawing conclusions about active vs. passive management, when in reality the data is simply the result of how one asset class performed as compared to another over a given period.

Fourth (and probably most important) thought: The very nature of index funds is such that they’ll rarely be the best (except over very long periods). Rather, in a given year, the lowest cost index fund in a particular asset class will generally be somewhere in the 60-70th percentile of funds in that same asset class. Of course, that leaves a significant number of funds which did in fact outperform the index.

Takeaway: If you want a strategy that is almost certain to put you above average, indexing is the way to go. Alternatively, if you’d like to take a shot at being in that top 30% each year, have at it. Just realize that for most investors, the chances are less than 50/50.

The way I see it, betting on actively managed funds is like playing blackjack at a casino. In any given hand (ie, year), your odds aren’t terrible. They’re just slightly below 50%. However, if you play 30 or 40 hands, it’s exceedingly unlikely that you’ll come out ahead.

Indexing, on the other hand, allows you to turn the table. Now you’re the house, and your odds each year (against every given actively-managed fund) are greater than 50%. Compound that advantage over a few decades, and you’re looking at some hard to beat odds.

In short

Would I ever say that index funds are unbeatable? Of course not. Not even close. But as far as I’m concerned, any investment option that assures (via simple, unquestionable arithmetic) that I’ll come out ahead of more than 50% of investment options in the same asset class is really darned good.

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  1. Very well articulated Mike.

    I agree with your points – for most folks – the index option is a good choice. There are many other active strategies that will outperform the index fund strategy at times, and underperform at others.

    Bottom line, depending on the kind of investor you are, the index strategy may be the one to go with.

    My experience tells me that investor personality type has a great deal to do with it.

    Anyway, this is a fantastic response and I really appreciate it. YOU ARE THE MAN MIKE!

  2. Indeed, it does come down largely to personality. Some people just won’t be satisfied with something as boring and simple as index funds.

  3. Excellent arguments! Your reasoning matches mine (and many others) very closely.

  4. It is indeed a well articulated argument for index funds. Not that it will convince the many buyers of active funds who think that they (or their advisors) are just a little better than average at picking them. It never ceases to amaze me that the same people who will agree they have no business picking stocks think that they can pick stock funds.

  5. “It never ceases to amaze me that the same people who will agree they have no business picking stocks think that they can pick stock funds.”

    Hehe. I’ll sign that statement.

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