Fund Indexers, Take (Another) Bow

For long-time readers of Free Money Finance, you know how I love index fund investing. I've posted about it several times including the following:

• The Case for Indexing
• Don't Give Up on Index Funds Yet
• Investing Made Easy, Part 2

As such, I just have to share a piece from Jonathan Clements at The Wall Street Journal on the advantages of index investing. Here are the key parts of the article:

Again and again in this column, I have argued that most stock-mutual-fund investors won't earn market-beating returns and that these folks would be better off buying market-tracking index funds. It turns out, however, that your chances of outpacing the stock-market averages are far slimmer than even I imagined.

The blame lies with investment costs, such as annual fund expenses and trading costs. After these costs are subtracted from the market's raw return, investors collectively pocket less than the market average.

This is where index funds get their edge. By aiming to mimic a particular market index while incurring modest costs, an index fund is sure to outpace most actively managed funds that invest in the same market segment, because the results of these active funds are dragged down by their far heftier expenses.

Well said! I have nothing to add to this.

Comments

[Jason]

Just want to sound off quickly on a couple of the overlooked risks in index investing (most people are well aware of fees). Disclaimer - I do not use index funds or ETF's at this moment in time.

1) Tracking error - The index funds themselves do not perfectly track their respetive indices for a variety of reasons, and one needs to be wary of index funds that do not track the indices that well. For example, if you compare ETSPX versus VFINX, you'll notice that ETSPX lags behind the index to a degree not explainable by its management ratio. It may seem like a small amount, but every basis point is important. More importantly, you may be taking some risks you aren't aware of.

2) Choosing a bad index - one of the advantages of index funds is their tax efficiency. This can be problematic if you choose a "bad index", where the underlying stocks see a lot of turnover (thereby forcing the index to sell/buy those stocks in order to accurately track the index). Again, this is relatively minor, but ought to be something you should look out for.

3) Focus on US Equity markets - If you go for indexing, then I think its safe to say that you are not aiming for highest absolute returns. In fact, you're probably looking to diversify your portfolio as much as possible (which in turn would reduce your risk AND return). But most people still do not diversify across asset classes, let alone geographical locations.

[jc]

Gimme a break!

1) Tracking error? Is that not the pot calling the kettle black or what?

2) Bad index? What the heck? A single index does not a portfolio make. Use index funds as ingredients in your overall asset allocation.

3) Indexing doesn't aim for highest returns? Well if beating three quarters of professional investors over the long haul isn't high enough returns for you then you need to cash out your brokerage and go to Vegas!

JC

[Jason]

JC,

1) I'm not quite sure what your complaint is there. Could you clarify?

2) Within any given asset classes, there are usually several indices that track said asset class. To buy more then one is essentially a waste of money - your diversification benefits are next to nothing. That's why its important to choose a "good index". Asset allocation is much more black magic then science.

3) It doesn't, by definition. If you read my post, you would have noticed that I specifically pointed out ABSOLUTE returns, i.e. returns above the risk free rate. You cannot take short positions in an index fund, nor are you always aiming to get treasury + x%, and if you do, then you probably aren't looking at passive indexing. Instead, you're diversifying your assets, reducing your risks, and therefore your returns.

Secondly, if the majority of professionals underperform the benchmark, then they are by definition a rather bad sort of group to judge your performance their indices is pretty pointless, they should be the same. Beating a professional matters only insofar as it helps you obtain your financial goals. If its via indexing, writing uncovered options, or collecting stamps, the way you go about it doesn't matter, as long as you get there. That being said, some ways are more likely to get you there then others.

[JC]

Nothing personal Jason; I'm sure you're a fairly bright guy. But your conclusions are seriously suspect.

1. The danger with tracking error lies with active management. By definition, indexing eliminates all but the most negligible tracking error. To hold indexing in suspicion because of "tracking error" is laughable.

2. You're right if you define a "good index fund" as one with low expenses. In that case, a bad index fund might be one that charges substantially more than Vanguard's equivalent offering. Also, you are entirely correct if someone views their redundant holdings as diversification (Say Russell 1000 and SP500 which both track US Large Market very well). Indeed, that would NOT be diversification. But when you say that asset allocation is more akin to black magic than science, you make another inane comment. Modern Portfolio Theory akin to reading tea leaves?? Please! My sides are splitting here...

3. By not trying to "beat the market" the passive investor usually ends up beating the vast majority of players in the market (professional and non-professional alike). Thus by indexing the passive investor earns an ABOVE AVERAGE return! How ironic! If the vast majority of professionals cannot beat the market, who do you think you are? Perhaps you're smarter than the army of Stanford educated MBA's hired by the largest institutions? Perhaps you have access to better technology and data? Perhaps you're better trained at exploiting market inefficiencies than they are? You believe that? Then step up to the table and place your bet my friend. My money's on the institutions. And in this zero-sum game they'll take your money without pity. And after you've learned your lesson in the woodshed, you will have learned from the best teacher there is: EXPERIENCE.

I humbly suggest taking the superior, above-average returns that passive indexing, MPT & asset allocation provides.

My 2 cents... But then again, perhaps I don't know what I'm talking about. It's your money after all...

Cheers,

JC

[Jason]

Hi JC,

Some more responses:

1) Negligble tracking errors are errors nonetheless - I'm not holding indexing in general suspect. I'm saying that you ought to be careful about which index fund you choose. A couple of basis points here and there might not seem like much, but it may add up over the long run.

2) Consider the assumptions in modern portfolio theory. You assume correlation amongst portfolios remains constant - this may or may not be true. If you watch EM bonds, you'll notice that the correlation with the US has decreased. Which means that you need to recalculate your asset allocation, otherwise you may be taking on additional risk which you're not aware of. This is not a trivial matter, after all, your goal is to be on the efficient frontier. This is complicated by the fact that we do not live in a world with only two securities, infinite liquidity, and no transaciton costs/taxes. Using a free asset allocator tool may be a good indicative guide, but I think it might not be a good idea to take those at face value (you don't know what's going into the model in the first place).

3) I don't think you read my comment about absolute returns. Absolute returns are just that, a set % each year. Indexing does not provide you with that. It can provide you with an EXPECTED return, but that's something else entirely. Efficient market theory suggests that you aren't getting above-average reutrns. Indexing CANNOT give you above-average returns because your benchmark IS the index, not other professionals. It has nothing to do with exploiting inefficiencies, it's just simple definitions. The only way you can gain above average-returns in an efficient market is to leverage yourself, which means you're taking above average-risk. Now if you don't believe in market efficiency, that's a whole different debate.

Best,

Jason

[JC]

My apologies, I couldn't resist:

1) Your point is irrelevant because you give us no alternative. If index funds are bad, every other alternative is worse.

2) You said I assume correlations remain constant. I make no such assumption! Indeed the risk/reward profile of an asset allocation may evolve. But this does nothing to prove your previous point.

3) Indeed absolute returns... yeah, I know. We've heard all that. But nobody earns absolute returns. You don't eat absolute returns. Investors earn geometric returns and those are the only returns that matter.

You said, "Indexing CANNOT give you above-average returns..." This is precisely the point I'm disputing. Passive indexing across poorly correlated asset classes DOES give you above-average returns!

You said, "The only way you can gain above-average returns in an efficient market is to leverage yourself" That is a patently false statement (although you do assert it with conviction). This is the point of MPT and the reason for asset allocation in the first place. I suspect that you're not well read in the tenents of Modern Portfolio Theory. Please realize: MPT asserts that passive investing DOES lead to above average returns (the overall portfolio is GREATER than the sum of its parts).

Yeah but... perhaps there's nothing to this nobel-prize winning MPT stuff. Maybe it's all a bunch of academic smoke & mirrors... Now if you believe that, that's a whole different debate.

You have the last word,

JC

[Jason]

Hi JC,

It looks like we may have to agree to disagree.

1) My point is not that all index funds are bad. Rather, what I'm saying is that some index funds are better then other index funds. VFINX is a superior fund to ETSPX because of the tracking error issue I mentioned earlier (though past performance is no guarantee of etc. etc.). Since it doesn't make sense to own both, why not choose the one that most closely tracks the index (besides logistical reasons)? It'll require a 10bp cost advantage for ETSPX to make up the lag they've suffered, why not go for VFINX?

2) But you cannot diversify your portfolio if you do not assume correlations between asset classes are constant. If you don't, then what you need to do is have a realtime calculation figuring out what correlation is at any given moment so you can adjust your portfolio accordingly. This obviously isn't practical. There may be no good solution to this (mathematically intensive, and how does one calculate expected return anyways?) - but geometric returns aren't what matters. The risk you take to get those returns is what is important - a return of 20% pa for 5 years or so is much less impressive if the way I've earned it is selling tons of options and leveraging on top of that. And if you do not know what the correlations are between your asset classes at any given time, you cannot calculate your risk. And if you cannot calculate your risk, it doesn't make any sense to talk about returns (in MPT, at least).

3) No, it does not. MPT says that a diversified portfolio is LESS RISKY then the individual sum of its parts assuming that not all assets are perfectly correlated, but with that comes the problem of reducing your return - there is no such thing as a free lunch. The efficient frontier represents the best return ADJUSTED FOR RISK. It is meaningless to talk about above average returns, because by definition it would not exist (if indexing consistently provided above average returns against some benchmark that isn't the index, everybody would pour in, reducing the returns to that benchmark). Returns only matter versus the risk taken. The easiest, and perhaps the only way to shove the efficient frontier up and to the left is via the use of hedge funds and private equity, or other alternative investments not available to the retail investor.

[Blaine Moore (Run to Win)]

I have not yet looked into purchasing any index funds, but I do plan on doing that. Right now, I am saving as much money as I can for a downpayment on a house; once that is done, I am going to revisit where my money goes.

[Donald]

I agree with buying index funds. It saves me lots of time. In fact, since I read FMF, I am investing in Vanguard LifeStratege Growth (VASGX)for my ROTH IRA. My wife is investing in Vangurd Total Stock Market Index (VTSMX). Cost-averageing.

[some body]

those who comment more than once per day disqualify from the drawing. cool - both jc and jason have maxed out their indices.

s.b.

[John]

I think that indexing is the way to go for most people who don't have time to research individual stocks or do anything fancy for their investments, yet still want to take advantage of the growth available in equities. You can never do worse than the market, and over longer periods of time, markets have shown a tendency to do quite well. No one can complain that they don't have time to make a smart investment.

[RS]

I currently invest mostly in index funds at Vanguard as well (I say mostly because I do have a small amount of "fun" money that I dabble in individual stocks with). I have the total stock market and the international stock market funds at Vanguard.

Having some problems with commenting...hope this finally goes through.

[beren9955]

The more I've read about them, the better investing in index funds sounds. I like the reduced risk, and more importantly, the reduced time expense. The next time I reallocate my 401k, I'll probably try to include some index funds in the mix.

re: #1, tracking errors -- some index funds/ETFs were notorious for poor transaction management... I think during the 90s, spiders were pretty bad. The Vanguard funds, on the other hand, are very good at tracking the index.