What is an index fund and why is it the best long term investment?
In my last article “Save your way to a better retirement through stocks” I outlined the long term advantages of stocks, and showed that they have outperformed all other asset classes in Canada and the US over long term periods. Due to “The miracle of compounding interest”, the longer the time frame you look at, the wider this gap in returns becomes.
Therefore if you are in your 20’s or 30’s and looking to save for retirement, it should now be clear that stocks will provide the most satisfactory returns. This brings us to the central point of this article, how can you take advantage of the long run superiority of stocks?
Investing in individual companies can be extremely rewarding for those who have a tremendous amount of insight and experience, but it can also be quite devastating when done by an amateur. Countless individuals have lost all of their savings by betting on one company (or a handful of companies) that proceed to collapse in value or go bankrupt. It is a lesson that you do not want to learn the hard way. Fortunately for the lay investor, it is possible to eliminate this risk through diversification.
Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. In this context it means buying a plethora of stocks, thus reducing the risk that your savings are significantly impacted by the bankruptcy of any individual company.
Two methods are readily available for the average investor to hold a heavily diversified portfolio; investing in an actively managed mutual fund, or investing in an index fund. While a mutual fund is run by a financial professional who is paid an obscene amount of money to attempt to beat the market by constantly buying and selling stocks. An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500).
Advantage of Index Funds over Mutual funds
Of the two, an index fund is typically a superior investment as it provides greater diversification that an actively managed mutual fund with lower operating expenses and lower portfolio turnover. The picture below shows the return from a $10,ooo investment from 1947–1997 in the average managed fund vs a balanced index fund.
Mutual funds are responsible for the majority of transactions that occur in a given day and compete against each other to form market average; thus cost plays the main role in determining results. The picture below shows that funds with the lowest costs perform the higher cost funds over the long term. In addition to this, No-load funds tend to perform funds which charge a front-end or back-end load. (A load is basically an additional fee which is charged for no good reason). Since a no load Index fund has the lowest cost, it also provides the greatest return.
Don’t pay higher fee’s for closet indexing
“taken to extremes, the process seems to work something like this: “I think Coca-Cola stock is grotesquely overvalued. But, in case it keeps going up, i’m going to buy 1.5 percent portfolio position for protection. Since that’s less than Coca-Cola’s 2 percent weight in the S&P 500 index, I’ll have a good defensive position versus the Index when Coca-Cola takes the tumble it so richly deserves.”… Such a closet indexing strategy is, in my view, more pervasive than most investors realize” — John Bogle, Common Sense on Mutual Funds.
It is this line of thinking which prevents investment professionals from achieving long term superior results over the market index. If you are going to get a portfolio that looks much like the market index anyways, you are far better off paying the lower fee’s associated with an index fund.
Index funds have far lower portfolio turnover, which limits transaction costs that dig into profits.
Below is graph showing the rise in the turnover rate of mutual funds over time. The higher this rate gets, the more the transaction costs will dig into profits
Why picking a mutual fund that beats the market is harder than picking a stock that does so
In the hopes of achieving higher returns, many investors believe that they can select the few mutual funds that will outperform the market index. However this is typically even harder than selecting individual stocks which outperform the market. Good results in the short term can be due to luck, taking excess risk, or following the crowd, all of which will backfire in the long-run
For this reason funds that are in the top quartile typically “revert to the mean” and go on to spend time in the bottom two quartiles. The chart below shows exactly that. The funds which were in the 1st quartile (highest returns) in the 1970’s provided the lowest return in the 1980’s.
Combine this with the fact that money usually goes into funds right after good performance (and thus right before poor performance) as shown in the figure below, and the returns actually earned by investors is far lower than the return which is broadcasted by the mutual funds.
In the rare case where a superior track record can be confirmed being a result of investing skill (known as alpha), the fund will attract huge amounts of investment capital, which in itself will make these results harder to duplicate. This is because their are limitations to how large a position a mutual fund can take in an individual security. In addition to this, mutual funds to not want to influence the price of the security with their own buying/selling.
All of this means that the larger the fund, the less stocks that it is able to purchase, and lower it chances are for superior results. The figures below show exactly that.
Another factor making it difficult to select superior mutual funds is that truly skillful fund managers are liable close their fund to new investors or retire shortly after a winning track record can be proven to be based on skill.
Parting Words Of Wisdom
Don’t just take my word for it, listen to the man who many consider to be the greatest investor to ever live; Warren Buffet.
“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” — Warren Buffett, 1993 Berkshire Hathaway Shareholder Letter