The following is an excerpt from Never Buy Another Stock Again: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity.
As the Swiss Finance Institute pointed out, it seems as if the ability of managers to beat the market is getting worse, and part of that has to do with the saturation of information in the marketplace itself. Compared with the 1930s and 1940s, when a truly dedicated manager could separate himself from others through analysis and attention to all of his investments, the asymmetric advantage has all but disappeared, despite what the professionals in the brokerage and mutual fund industries would contend.
This brings us back to index funds. John Bogle, longtime head of Vanguard Funds, established the first true index fund in 1975, designed to track the performance of the S&P 500 index. The aim was simple: to provide the best performance at the lowest costs, referring to what he called “the great irony of investing”—that you “get precisely what you don’t pay for. So if you pay for nothing, you get everything.”
He hasn’t been wrong. Vanguard’s Index 500 fund has mustered returns that have outpaced about 85 percent of the mutual funds in the last few decades. And that is, again, without doing anything but passive investing. That does not mean, however, that index funds are a monolith. There are nearly 200 index funds and exchange-traded funds tracking the S&P 500, and their performance does vary due to differing expenses underlying each of these funds. Some of the funds in question have surprisingly high expense ratios.
For instance, the Rydex S&P 500 “A” shares sport an expense ratio of 1.52 percent, according to Morningstar, the mutual fund research firm in Chicago. If it’s pointless to pay a lot of money for a fund manager who is at least trying to beat the market, it’s even more pointless to see returns eroded by a manager who isn’t even trying! Returns are drastically impacted by this as a result. Over the last five years through November 13, 2009, the annualized five-year return of the S&P 500 is 0.48 percent. The iShares S&P 500 index, one of the more popular exchange-traded funds that mimics the S&P, has a return of 0.45 percent, so it’s just a fraction behind the actual index, which makes logical sense.
The Vanguard 500 Index offerings come in several classes of shares; some of them, including the institutional shares, are actually outdoing the S&P by a few hundredths of a percentage point. The most well-known, though, the Vanguard 500 Index Investor Fund, established in 1976, has a total annualized five-year return of 0.40 percent. Naturally, it trails the S&P 500, but again, only by its costs.
The same can’t be said for others. There are a number of index funds, including some that have been around for a couple of decades, which are providing no benefit to picking an index fund. Dreyfus’s S&P 500 fund is up just 0.04 percent in the last five years; T. Rowe Price’s Index fund has a return of 0.25 percent over the last five years, owing in part to an expense ratio of 0.35 percent, more than double that of Vanguard’s 0.16 percent and more than triple that of Fidelity Spartan’s ratio of just 0.10 percent.
These differences are not trivial. An investment of $10,000 in a fund that compounds at an 8 percent annual rate—optimistic, but let’s go with it—will, after 35 years, be worth $147,853.44. Cut that down by half a percentage point to 7.5 percent, and that return drops to $125,688. And this isn’t even complicated—it’s not work at all to pick an index fund as it is to try to pick stocks. Losing money as a
result of high expenses in a fund that’s supposed to be doing just what the most popular market barometer is doing is downright foolish.
Some say an index that tracks the S&P 500 is the wrong way to go in the first place, despite the S&P’s popularity as a market barometer. Burton Malkiel, author of A Random Walk Down Wall Street, argues that the transaction costs embedded in the cost of buying and selling issues that come in or leave the S&P 500 hurts returns. He suggests a broader index, such as the Wilshire 5000 or the Russell 3000, because those indexes cover a larger portion of the market. Because of this, the transaction costs are a bit lower, so the spread between the index’s performance and the returns of index funds is smaller. Secondly, the best outperformance in stocks is often found in the smallest issues. The S&P 500 accounts for about 75 to 80 percent of the market’s total capitalization, but it’s that other 20 percent that provides the most opportunity for big rewards, he argues.
This assertion, however, is somewhat belied by statistics. The Wilshire 5000 and Russell 3000’s returns are on a par with the S&P 500 over the last two decades, so whatever difference comes from getting a benefit from having smaller companies in one’s portfolio is eroded by the poor performance of other components. An investor, however, who truly wanted to overweight growth companies could buy indexes that track the Russell 2000 along with a Russell 3000 index fund—this then overweights small growth-oriented shares, again, also for a low cost.
Others argue that indexes that are weighted in favor of capitalization—that is, the index is more directly influenced by the biggest companies in the index—are part of the problem. The Standard & Poor’s 500-stock index is a popular index, but a great percentage of the daily shift in the index is accounted for by several dozen of the largest stocks, such as Apple, Microsoft, Exxon Mobil, Wal-Mart and the other well-known names. Those investors argue that a “fundamental indexing” approach, one that is less sensitive to market capitalization and price, is a better approach. Rob Arnott of Research Affiliates has created a number of these indexes at his firm—they weigh stocks based on several criteria, including their underlying value, cash flow, sales, and dividends. How does this help? It avoids the problem of overweighting stocks that have run up dramatically and therefore become overrepresented in an index, like technology did at the end of 1990s and as financials did at the end of this past decade. “Each new day brings further empirical evidence that weighting securities by capitalization is the index fund’s Achilles’ heel,” he wrote in a January commentary. Of course, that presents the challenge for investors on how to avoid that as well (other than handing over money to Mr. Arnott, who, as smart as he may be, cannot manage the retirement funds of the entirety of the U.S. public). Investors can on some levels tackle this problem through equalweighting of other types of indexes or ETFs of other asset classes or parts of the market, which we will discuss more later.
In addition, other asset classes are worthy of consideration, both in the U.S. and outside the U.S., that will help offset losses in other areas of one’s portfolio with a modicum of effort. Foreign stocks are occupying a larger place in investors’ portfolios in recent years for good reason, along with small stocks, long-term government bonds, short-term cashlike instruments such as Treasury bills and money market funds, and stocks invested in hard assets such as gold and oil, which tend not to react in the same way to the rest of the market.
So, what, then, can investors do to help offset their risk and protect their portfolio from losses? The passivity argument helps keep costs low, but in a nowhere market, it’s not all that useful, and you’re going to need more from your investments as you should. There are a number of possibilities. Some of these are easy. Rebalancing on a yearly basis in one’s 401(k) allocation is a snap—particularly for those who can do so automatically when they enroll in their plan. Establishing a level at which one should sell assets, such as ETFs or other investments, after a certain percentage loss is a bit more difficult, but there are strategies that attempt to go this way to keep losses minimal. (Anyone who immediately exited hot tech funds after it lost 15 percent of its value in 2000 saved themselves a lot of pain. The downside? When there are occurrences like the May 6, 2010 “flash crash,” when popular stocks were suddenly traded briefly at a penny, a level that would have triggered sales for many investors.) Keeping a bit of money in Treasury securities that track rising inflation can help guard some of the portfolio against losses.
Other strategies, which will be discussed, involve putting a cap on the losses one will tolerate before shares in index funds or ETFs are sold and allocating funds among a number of different asset classes, more than you’re used to doing in the past. Some of these ideas have their own pitfalls, and there are still plenty trying to come up with a better mousetrap that will solve everyone’s problems with a simple formula. No such formula exists.
There are other ways to keep one’s head up, avoid sticking it into the sand, while still avoiding panicked decisions, and a lot of this is learned behavior that comes from making mistakes.
More of this will be discussed in coming chapters, but first it’s worth looking at diversification. We need to go through how seemingly diversified portfolios can get crushed in a market where assets all move together at the same time—and figure out what assets will truly hang tough when all sorts of stocks or commodities are falling at the same time. Getting this right will keep you from lying awake at nights worrying about your purchases or have you stressed out in front of the computer when you have other things to deal with, such as a job, a home, and a family.