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Why Use Index Funds? (It’s About Costs.)

I recently came across a conversation on the Bogleheads Forum in which somebody referred to me as an “indexing extremist.”

At first it just made me laugh. I have a hard time seeing myself as an anything extremist given the quantity of parenthetical explanations and qualifiers (“generally,” “usually,” “tends to,” etc.) that I tend to use.

But the more I thought about it, the more I realized that it’s possible (likely?) that I’ve overstated (or misstated) the case for index funds.

Let’s back up a step in the hope of clearing things up.

The Magic of Indexing?

There’s nothing truly magical about indexing. Or, if there is, it’s just that it’s a very inexpensive way to run a mutual fund without having to sacrifice diversification.

There are some other, less important benefits — like not having to worry that your fund manager will do something dumb with your money. But low costs are the big thing here.

There’s no particular reason to think that having a portfolio in which each investment is weighted according to its market weight is in itself, going to improve your returns. In fact, for most investors, it doesn’t make sense to market-weight your entire portfolio. For example, consider your bond allocation:

  • For investors in high tax brackets investing in taxable accounts, it makes sense to overweight tax-exempt bonds.
  • Conversely, for investors exclusively using tax-sheltered accounts (IRA, 401(k), etc.), it makes sense to underweight tax-exempt bonds — all the way to zero, most likely.
  • For investors who are very exposed to inflation risk, it likely makes sense to dramatically overweight TIPS relative to their market weighting.

In other words, we each have different needs. And as a result, it makes sense for each of us to hold a portfolio that’s different from the market portfolio in one way or another.

Costs Matter.

But index funds (and ETFs) do tend to be the least expensive way to invest. And as it turns out, that’s no small benefit.

As Russel Kinnell of Morningstar wrote last year when summarizing a study he’d done,

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

Or consider an earlier study, also from Morningstar:

“In all categories, funds in the cheapest quintile were more than twice as likely to succeed–that is, beat the average for their categories-than those in the most expensive quintile. Success declines rapidly as you move up in price. Of domestic-stock funds, 47% in the cheapest quintile succeeded over a 10-year period, 33% of the next cheapest quintile succeeded, 30% of the middle quintile succeeded, 27% of the second priciest quintile succeeded, and just 19% of the most expensive quintile beat the category average.

That same general conclusion has been shown by study after study: Lower-cost funds tend to outperform higher-cost funds.

And because index funds and ETFs tend to be the lowest-cost option available, they’re usually a darned good bet.

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Comments

  1. Great meeting you this weekend Mike. Excellent post. One additional benefit of indexing, they are a great asset allocation tool. Index products that closely track their underlying index are often much more style pure than many active products. If one believes (as I do) that asset allocation and rebalancing are key factors in risk control and investment success, index funds/ETFs are a natural.

  2. Hi, Roger.

    I enjoyed meeting you this weekend as well. And I agree with your point of course. It does make asset allocation implementation easier when you know the allocation of each of your funds. 🙂

  3. Haha, extremist? Wow, I will vouch that is the wrong word for you. Passionate about index investing, but definitely not an extremist.

    I love index funds for their low costs. When I first started investing for retirement I just followed what the financial adviser’s picks. They were high cost funds that didn’t really do much.

    After crunching the numbers, I saw it would be better to avoid actively managed funds. I’ve stuck with index funds for the most part since then.

  4. Thanks for backing me up, Elle.

    I’m happy I finally had the chance to meet you this weekend. 🙂

  5. Low cost funds beat high cost fund, true. Absolutely lowest cost funds beat slightly higher cost funds? Not necessarily. Those DFA funds favored by financial advisors aren’t strictly index funds. They aren’t the lowest cost funds either. When you get the cost low to a certain point, other aspects start to matter. You don’t have to go by the absolutely lowest cost funds.

  6. TFB,

    Even if you can get an actively managed fund that is low cost- it might underperofrm it’s index. It is hard to beat the indexes- many actively managed funds don’t beat their index even before costs.

    So, if you don’t go with indexes how do you pick the winning funds? That turns out to be really hard as well- remember past performance is NOT a predictor of future performance. A winning fund one year can end up underperforming another year.

    Bill Schultheis has a great argument for index funds- Why risk trying for the best fund when you can pick the index and guarentee you will beat most funds? It makes as much sense as trying to out fox the box:
    http://www.coffeehouseinvestor.com/investing-you-understand/outfox-the-box/

    -Rick Francis

  7. @Rick Francis – I didn’t say it would be easy to pick winning funds. Since the premise of Mike’s post says indexing’s advantage is its low cost, I only wanted to point out that funds with absolutely lowest costs don’t automatically win over funds with slightly higher costs. Within index funds, some providers try to undercut Vanguard by a few basis points. Do they automatically win by the few basis points? Not necessarily. Beyond index funds, other factors, for example deeper value or smaller small, play a role as well.

    Speaking of actively managed funds, the latest SPIVA scorecards show the index advantage at 60-65% level, not the 80% level in “out foxing the box.” The variations also aren’t as high as the boxes. In large value, 65% of active funds beat the index in the last 5 years and that was including the high cost funds. When you weed out the high cost funds, you would think the scorecard would come close to a coin toss if we follow the logic in Mike’s post.

    I don’t invest in actively managed funds myself but I have no problem with others investing in low cost actively managed funds. After you eliminate cost as a substantial factor, which funds will have higher returns in the end is much harder to determine ahead of time.

  8. I only wanted to point out that funds with absolutely lowest costs don’t automatically win over funds with slightly higher costs.

    I agree with this conclusion, by the way. And I think it’s helpful to take it a step further: The absolutely lowest-cost funds don’t automatically win over funds even with much higher costs.

    There isn’t much that’s automatic when it comes to predicting fund performance. Any investor looking for that degree of cetainty is likely to be disappointed.

  9. By “automatic” I mean “a significantly higher than 50/50 chance” — not certainty. I just read a thread on the Bogleheads forum about various international value and small cap ETFs. The ETFs mentioned in the thread have somewhat different expense ratios but they are all low enough. At that point, the composition of the ETFs starts to matter. One of the choices happens to be an actively managed fund (Vanguard’s international value fund). Because its cost is low enough, it’s worth considering as well.

  10. The Wealthy Canadian says:

    Nice post!

    Despite the fact that I have dividend stocks as a key part of the equity component of my overall portfolio, recently I have decided to incorporate low-cost funds and ETFs as part of my overall investment strategy.

    I totally agree in that many index funds & ETFs can often be inexpensive to own, and I’m currently seeking out quality equity and bond index funds as part of my portfolio. Vanguard’s VEA intrigues me, and I like the international diversification it offers, coupled with a low expense ratio.

    Cheers,
    TWC

  11. Hi Mike — After hearing such great things about you and your blog last week in Chicago, I had to swing by.

    This post agrees with everything I’ve said about investing — that expense ratios (plus trading costs and taxes) will eat away at any potential extra gain that an actively-traded fund posts. The best strategy is to index to the overall market.

    Fortunately for me, that’s also what I call the “lazy” method — just figure out your allocation, toss it into some index funds or ETFs, contribute monthly, re-balance yearly, and relax.

  12. Hi Paula. Thanks for stopping by to comment. It was a pleasure meeting you (albeit briefly) last week.

    Sounds like you and I are on the same page. 🙂

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