Index Funds Win Again

Here's yet another piece that touts the advantages of index funds -- this time from the NY Times. The conclusion:

There's yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

Basic stock market index funds generally aspire to nothing more than matching the returns of a market benchmark. So in a miserable year for stocks, index funds may not look very appealing. But it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.

The piece goes on to detail the work and findings of Mark Kritzman, president and chief executive of Windham Capital Management of Boston and professor of financial engineering at M.I.T.’s Sloan School of Management, where he compared index funds to actively managed funds and hedge funds. The simplified summary: actively managed funds perform better before expenses are subtracted. But once expenses are deducted, index funds are the better choice. Their words:

Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.

If such outperformance isn’t enough to overcome the drag of expenses, what would do the trick? Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.

As I've said before (probably a hundred times now on this site), costs matter BIG TIME when it comes to investment returns (that's why I've taken extra steps to get my investing costs as low as possible.) And that's one reason I like index funds -- they keep investment costs to a minimum and thus keep total returns as high as possible.

For more thoughts on index funds, see these posts:

• Warren Buffett Bets on Index Funds

• Index Funds Get Even Better

• More on Costs Killing Your Investments

• An Investment Portfolio Using Only Three Index Funds

• How Fees Eat Your Lunch -- It Still Adds Up To Dollars

Comments

[Sue]

Ummm... I have Vanguard index funds available in 401K and I wouldn't touch them - returns across all of the available funds both YTD and 12 Month are negative 30%-50% - don't think now is the time for index funds! and what about the give-back of returns for past 10-12 years? (And these are no-fee so that issue isn't relevant.)

I think to compare lo-fee index funds to managed or hedge is easy to make points - but it's the index itself that's risky.

I'm up YTD because I got OUT of index funds - and minimal losses (2%) for 2008 - so just curious, why do you advocate losing money in an index fund, at least short term (1-2yrs)?

[FMF]

Sue --

Because I don't invest for the short-term -- I have a 20-year plus time horizon. Moving back and forth into and out of stocks/funds is market timing, something I don't subscribe to. Why? Because no one can do it consistently, and it will eventually burn you bad.

So you timed it right this time and basically got lucky, but will you miss a resulting run-up as a result? Only time will tell. The one thing I do know: if you could accurately predict the ups and downs of the market, you wouldn't be commenting on this blog -- you'd be vacationing with Bill Gates in Bermuda!! ;-)

For more thoughts along this line, see this post:

http://www.mymoneyblog.com/archives/2009/03/chart-historical-stock-market-comebacks-after-crashes.html

[My Life ROI]

FMF --

Gotta keep hammering this point. Eventually people will take notice.

MLR

[Jim]

FMF, one point about that NYT article is that they are including the tax implications. And they say that taxes account for 2/3 of the expense difference or 2.3% difference. With taxes the index came out 8% average and mutual fund 8.5% average. So without taxes I'd expect you'd add back that 2.3% difference and the active funds would be 1.8% ahead of the index on average. Plus they are assuming the maximum possible tax bracket rate for their calculations. The overwhelming majority of folks do not pay max tax rates. I think since most people seem to have their stocks in an IRA or 401k the tax implications would not be an issue.

[Jim]

I meant that the index was 8.5% and the active fund was 8.0%. I got it backwards above.

[F]

Jim,
good point!
However the fact that you have to pay such high taxes on hedge funds, is something new for me.