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Index Investing – Myths and Facts

Thursday, April 29, 2010   

Index investing, an approach that attempts to mirror the performance of market indices at minimal cost, has been maligned and misunderstood for decades.  The criticism began even before Vanguard founder Jack Bogle created the first index mutual fund in 1975, as the concept was prematurely labeled as “Bogle’s folly.”  Upon creation of the fund, which would later become the Vanguard 500 Index Fund, Fidelity Chairman Edward C. Johnson III was asked if his company would follow Vanguard’s lead.  He replied, “I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns.”

Today, the Vanguard 500 Index Fund is the largest mutual fund in the world, and Vanguard has succeeded in creating dozens of additional index-based mutual funds and ETFs.  Nevertheless, skepticism and misinformation about index investing still abound.  For the most part, the financial media encourages short-term trading and market timing, dismissing a low-cost, disciplined approach with phrases like “doomed to mediocrity” and “buy and hope.”  With this in mind, I thought I’d do my best to expose some of the most commonly perpetrated myths about index investing.

Myth #1:  Index funds only perform well in bull markets.

Fact:  Standard & Poor’s 2008 Indices Versus Active Funds Scorecard found that the majority of active funds failed to outperform the relevant index in eight of nine domestic equity style boxes during the financial crisis of 2008.  International and emerging market indices demonstrated similar superiority, and fixed income indices were even more impressive.  According to the report, “the bear market of 2000-2002 showed similar outcomes.”

Myth #2:  Index investing is for inexperienced investors who don’t know how to properly analyze individual stocks.

Fact:  Sophisticated investors such as pension plans, university endowments, and wealthy families have been indexing for decades.  In addition, some of the brightest minds in finance today, names like Bernstein, Bogle, Malkiel, Sharpe and Swensen, are zealous proponents of index investing.

Myth #3:  Index investing consists of buying one fund, an S&P 500 index fund, and holding it forever.

Fact:  An intelligent index investor analyzes his risk profile, builds a diversified, risk-appropriate portfolio of equity and bond index funds, and periodically rebalances his portfolio to maintain his target allocation.  Some of the first index investments mirrored the S&P 500 Index, but in today’s investing marketplace, there are hundreds of index-based mutual funds and ETFs from which to choose.

Myth #4:  To be an index investor, you have to believe that markets are perfectly efficient.

Fact:  The case for index investing does not rest solely upon the validity of the Efficient Market Hypothesis.  In order to view indexing as the best long-term investing approach, one only has to believe that markets are efficient enough that individual investors cannot legally and consistently profit from mispriced assets through an actively-managed investment vehicle.  The vast minority of investing theorists believe that our financial markets are perfectly efficient, indexing proponents included.

Myth #5:  Any decent mutual fund manager can beat the index.

Fact:  Each year, in every fund category, there are mutual fund managers who beat the index.  Unfortunately, there’s no reliable way to pick future winners, and the number of repeat winners is consistent with the laws of chance, not skill.  In a typical year, according to data from Morningstar and Barclay’s Global Investors, about one-third of active managers beat the relevant index, and 10% of those managers sustain their outperformance over the next two years.  Even the most saavy, educated fund manager faces an extremely difficult task in attempting to overcome the costs of active management.

Myth #6:  Index investors have to settle for mediocre returns.

Fact:  According to data compiled by the Bogle Financial Markets Research Center, 80% of actively-managed mutual funds fail to beat a comparable index fund over a typical 20-year period.  The 80th percentile is far from mediocre, but the results are even more astounding when you compare an index portfolio to a portfolio of actively-managed mutual funds.  Independent studies by Rick Ferri and Allan Roth recently found that over a 25-year period, a portfolio consisting of 10 actively-managed funds has about a 1% chance of outperforming a comparable portfolio of index funds.  I wouldn’t want to bet my retirement against those odds.

Reminder:  Need an opinion on a risk-appropriate asset allocation? Get a FREE portfolio recommendation today!

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