BASHING OF INDEX FUNDS

The bashing of Index Funds, Jack Bogle and a Jedi dog trick

by jlcollinsnh 43 Comments

Over on Magic Beans reader Mark had this to say in the comments:
“Being a Boglehead myself, I read the ERE article to see what he had to say. I had to sigh when I got to this: “Index investing is basically equivalent to a buy and hold strategy with very low turnover of a few large growth companies.” This is absurd. The S&P 500 is just one index. There are indexes for large cap, small cap, growth, value, US, Europe, emerging markets, REITs, every kind of bond, you name it. Index investing is about choosing an asset allocation that matches your need and willingness to take risk, and using low-cost index funds to hold the most diversified position possible within those asset classes. Why is it that the people bashing “index investing” have so little understanding of what it is?”

It’s not just people bashing Indexing Mark, it’s an entire financial industry.

In addition to offering some good points, Mark got me thinking about just why it is that concept of Index Funds meets with such resistance in some quarters.  First, a little background.

Jack Bogle founded the Vanguard Group in 1974 and launched the first index fund,  the S&P 500 Index, in 1976.  The  basic concept with Vanguard is that an investment firm’s interests should be aligned with those of its shareholders.  To this day it is the only firm that is and as such is the only firm I recommend.

The basic concept of indexing is that, since the odds of selecting stocks that outperform is vanishingly small, better results will be achieved by buying every stock in a given index.  This was soundly ridiculed at the time and in some quarters it still is.

But quickly and increasingly over the past 36 years the truth of Bogle’s idea has been repeatedly confirmed.

After replying it occurred to me this is a subject that deserves a post of its own.  Below is my slightly expanded response to Mark.

Hi Mark… Always good to meet a fellow Boglehead.

Warren Buffet is typically held up, with good reason, as the pinnacle of all that is good in investment.  He certainly has an impressive record.

But for my money (pun intended), no one has done more for the individual investor than Jack Bogle.  From Vanguard and its unique structure that benefits shareholders to Index Funds,  he is a financial saint and a personal hero.

You are, of course, correct. The S&P Index is only the first of its kind and now is one of many. Each tailored to a unique need. As mentioned elsewhere I use/need only two, plus a money market fund.

As to why people bash them with little understanding, all I can say is that seems to be a common human trait.

I have a lot of respect for Jacob and ERE. He’s clearly very bright and thoughtful. Why he choose to dismiss Indexing in the manner he does, baffles me.

As to why people who do take the time to understand indexing and who still reject it, I think there is a lot of psychology behind it:

1) It is very hard for smart people to accept that they can’t outperform an Index that  simply  buys every thing. It seems it should be so easy to spot the good companies and avoid the bad. It’s not. This was my personal hangup and I wasted years and many $$$ in the pursuit of out-performance.

It should be easy to spot the bad ideas, right?

2) To buy the index is to accept “average.” People have trouble seeing themselves or anything in their life as average.
But in this context “average” is not in the middle, it is the performance of the all the stocks in an index.  Professional managers are measured against how well they do against this return. In any given year, and of course this varies year to year, 80% of actively managed funds underperform their index.  This means just buying the index guarantees you’ll be in the top performance tier.  Year after year. Not bad for accepting “average.”  I can live (and prosper) with that kind of “average.”

3) The financial media is filled with stories of individuals and pros who have outperformed the index for a year or two or three. Or in the rare case, like Buffet, who has done it over time. (I cringe at the often touted suggestion to just do what Buffet does.)  But investing is a long term game.  You’ll have no better luck picking and switching winning managers than winning stocks over the decades.4) People underestimate the drag of costs to investing. 1 or 1.5 or 2 percent seems so low, especially in a good year. Fees are a devil’s ball & chain on your wealth.  As Bogle says, performance comes and goes. Expenses are always there.*
5) People want quick results. They want to brag about their stock that tripled or their fund that beat the S&P. Letting an Index work its magic over the years isn’t very exciting. It is only very profitable.
6) People want exciting. Heck, I’ve even admitted to playing with individual stocks with a (very) small fraction of my stash. But I let the Indexes do the heavy lifting and they are the ones that got me F-you Money.

7) Finally, and perhaps most influential, there is a huge business dedicated to selling advice and brokering trades to people who believe they can outperform. Money managers, mutual fund companies, financial advisers, stock analysts, newsletters, blogs, brokers all want their hand in your pocket. Billions are at stake and the drum beat marketing the idea of out-performance is relentless. In short we are brainwashed.

Indexing threatens the huge fees they can collect enabling your belief and effort in the vanishingly difficult quest for the alluring siren of out-performance.
Use The Index and keep what is yours.


Addendum I:

On a fairly regular basis I’m asked what would happen were all money to be indexed. I’m afraid I find this question almost completely uninteresting. The reason being, it is never going to happen.

What is interesting to me is that only ~33% (so I’m told) is currently being indexed. This is remarkable in that the research has for over 30 years shown indexing to be the most powerful investing strategy. 30 years of study after study coming to this conclusion and still 64% of investors DON”T index? That’s what’s stunning.

But they never will for the reasons provided in this post. And, of those, perhaps #7 is the most critical.

There is relatively little money to be made running index funds. There are huge fortunes to be made selling and running actively managed funds. There will always be the naive, ignorant or arrogant who will be easy prey.

The fact that there is so much money at stake hoping to prove active management has value, makes the research supporting indexing all the more compelling.

Addendum II:

*In addition to underperforming Index Funds, actively managed funds cost more, and those costs have a very serious and negative impact on your results. My pal Shilpan has a great post on this:  That Mutual Fund is Robbing Your Retirement
Addendum III: Warren Buffett’s plan for his widow
Addendum VI: Donald Trump would be 10 billion dollars richer if he read this blog.
Addendum V: At various points on this blog I suggest only about 20% of active managers out-perform the index. That’s being a bit generous.

This is a ball park figure based on the many articles on this I’ve come across on this over the years. In fact you can Google this question and find several falling around this percentage. I’m not sure why they vary. Some look at different time frames. Some at different metrics. Some factor in costs, some don’t.

Clearly it is easier to get lucky and outperform the shorter the time you need to do it. Even I called the market almost exactly last year, and I can assure you it was no more than luck:  https://jlcollinsnh.com/2014/01/01/1st-annual-louis-rukeyser-memorial-market-prediction-contest-2013-results-and-your-chance-to-enter-for-2014/

Vanguard has done research on this looking at a 15-year time frame:
https://personal.vanguard.com/us/insights/article/infographic-outperformance-112013
In it they point out that 45% of actively managed funds fail to even survive over that time, let alone outperform. Only 18% both survived and outperformed. And even those frequently had long periods of underperformance.

So even if you are lucky enough to pick one of the out-performers, it will be tough to live with.

This article references studies done for an even longer period: 1976-2006, 30 years: http://www.marketwatch.com/story/almost-no-one-can-beat-the-market-2013-10-25

The results are even more shocking. As the article says:
“Barras, Scaillet and Wermers tracked 2,076 actively managed U.S. domestic equity mutual funds between 1976 and 2006.

“And — are you sitting down? Only 0.6% — you read that right, 0.6% — showed any true skill at beating the market consistently, ‘statistically indistinguishable from zero,’ the three researchers concluded.”

Always ask, Where are the missing bullet holes?

On reflection, calling the out-performers at 20% I am too generously off the mark.

Trump v. Index

Trump Worth $10 Billion Less Than If He’d Simply Invested in Index Funds

Forbes reports Donald Trump is worth $4.1 billion; Trump says $10 billion. Either way, he'd be worth a lot more if he simply retired 30 years ago and put his money in an unmanaged stock fund.

Donald Trump traveled an old-fashioned route to fortune.
As he explained when he announced his bid for the 2016 Republican nomination for president:
“I made it the old-fashioned way. It’s real estate. You know, it’s real estate.”
While Trump did have a big head start — his father, Fred, was a multimillionaire New York real estate developer — there’s no doubt The Donald has created a fortune of his own. But if he’d stopped working 30 years ago, he could have done much better.
All he had to do was shift away from real estate and park his money in the same place that you can: an unmanaged stock index fund.

The background

To compare Trump’s performance to that of an unmanaged index fund, we need to know two things: his beginning net worth and his current net worth.
There’s considerable debate about Trump’s net worth. It’s estimated at $4.1 billion in the latest “Forbes 400” list, which puts him in the No. 133 spot of the richest folks in America. However, in July, he issued a press release announcing his net worth at $10 billion.
Fine. Let’s give him the benefit of the doubt and assume his net worth is $10 billion.
Now we need to establish his net worth at some point in the past.
Trump was on the Forbes 400 in 1982, when the magazine published its first annual list of America’s wealthiest denizens.
That year, Forbes said Trump’s fortune was “estimated at over $200 million,” but also acknowledged that Trump claimed it was “$500 million,” according to Timothy L. O’Brien’s book “TrumpNation: The Art of Being The Donald.”
Again, let’s give Trump the benefit of the doubt and assume he was worth $500 million in 1982.

The math

Imagine Trump had retired in 1982, sold his real estate holdings and invested his $500 million in the S&P 500 — that is, 500 stocks representing the American stock market.
From 1982 through the end of 2014, the S&P 500 index had an annualized return, including reinvested dividends, of 11.86 percent, according to MoneyChimp’s S&P 500 Compound Annual Growth Rate calculator.
Per this calculator, every dollar invested in January 1982 would have been worth $40 by December of 2014. That means Trump’s initial $500 million would have grown to $20 billion. That’s twice what Trump says he’s worth today.

You can beat The Donald

This comparison is notable for two reasons. First, it reveals that Trump may not always be as shrewd as he’d have you believe, especially considering he’s filed four corporate bankruptcies since 1982.
More relevant to your life, however, is that you can do what he didn’t: harness the twin tools of stocks and compound interest.
While few of us have the resources to invest in the stocks of 500 of America’s largest companies, nearly all of us have the ability to do so through mutual funds, like an S&P 500 index fund.
You probably have an S&P index fund, or something similar, in your 401(k) at work. They also can be found at nearly every investment firm, either as a mutual fund or an exchange traded fund, commonly known as an ETF.
If you decide to take on more risk and chase The Donald, you will need to make a couple of important decisions:
1. Pick an asset class. You could buy stocks or bonds, as well as choose from a slew of other alternative investments. To keep things simple, however, nothing wrong with sticking with just stocks and bonds.
Many experts urge average investors to put their money in mutual funds rather than buy individual stocks and bonds. You can choose a stock mutual fund, a bond mutual fund or a portfolio of mutual funds that includes both stocks and bonds.
In our hypothetical example above, we chose a pure stock mutual fund. That’s because, in the long run, stocks offer a greater rate of return than other asset classes such as bonds.
As Money Talks News founder Stacy Johnson explains in “Beginning Stock Investor? Here’s All You Need to Know“:
Depending on how you measure it, stocks have averaged 8 percent to 10 percent annually over the last 100 years. Of course, stocks entail risk; that’s why they pay more.
Fortunately, mutual funds help mitigate risk because they are made up of a wide variety of stocks. That helps spread the risk — if one company in your mutual fund goes bankrupt, it won’t wipe you out.
2. Pick active or passive management: Actively managed stock mutual funds are run by financial professionals who decide which individual stocks within the fund to buy and sell. They make these judgments based on their expectations of future market performance.
Such managers aim to outperform stock market indices — and they charge higher fees for their effort.
Passively managed stock mutual funds, often referred to as index funds, simply aim to mirror the success of a stock market index.
Here’s Johnson again:
Owning an index fund is like owning the entire stock market, as represented by an index, like the S&P 500. Since all an index fund manager has to do is buy the stocks in the index, a chimpanzee could do it. And because management is simple, the fees charged are minimal.
Study after study has shown that index funds historically have performed better — at a lower cost to the investor — than managed funds over a long period of time.
Johnson is hardly the only expert who champions index funds.
Warren Buffett, billionaire investor and CEO of Berkshire Hathaway, made headlines last year when he wrote in his annual letter to shareholders that his fortune is destined for index funds. Buffett wrote of the instructions laid out in his will:
My advice to the trustee could not be more simple: Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
Perhaps that wisdom is why Buffett is in the No. 2 spot on the Forbes 400.