Five Myths and Misconceptions about Indexing

Vanguard lists five myths and misconceptions about indexing as follows:

• Myth #1: Indexing only works in "efficient" markets
• Myth #2: Who wants to be "average"?
• Myth #3: You get what you pay for—Higher cost + Higher ratings = Higher returns
• Myth #4: Market-cap weighting overweights the overvalued
• Myth #5: Index funds underperform in bear markets

The myths I want to highlight are #2 and #3.

I've had many people say to me that they don't want to "settle" for average returns which are what they believe index investing provides. However, this is not the case. Indexing provides average gross (before expenses) returns, but once costs are deducted, indexing provides superior net returns (which are what you actually take to the bank). Here's how Vanguard puts it:

The reality is that index funds, in their attempts to deliver the average returns of all investors in a particular market, have delivered far-from-average performance.

An important reason for this is cost. Indexing has proven to be a low-cost way to implement an investment strategy, lending a significant tailwind in producing above-average returns over the long term relative to higher-cost active strategies. For example, 84% of active small-cap blend funds and 71% of active emerging-market funds underperformed low-cost index funds for the ten years through 2013.

Can some investors beat index investing? Yes. Can a very few do it again and again for decades? Yes, but only a handful. Does doing so require a good amount of skill, time, nerves of steel, and even luck? Yes. In other words, most people (even professional fund managers) can't beat indexing -- the odds are stacked against them. So why try? Instead, spend your time and effort working on growing your career -- something you can impact and which will yield much bigger dividends in the long term.

Closely tied to the net return is costs, which Vanguard addresses in myth #3. Their thoughts:

The "higher the price, the better the product" myth is another intuitive, everyday maxim. In investing, it would seem to be translated as: "We can expect to enjoy higher returns from expensive or highly rated managers."

However, the reality in investing is that this seemingly commonsense relationship is reversed—you often get what you don't pay for (that is, higher performance is frequently equated with lower cost). Perhaps even more unintuitive is that highly rated funds have actually underperformed their lower-rated peers.

They then show a couple of charts that illustrate these points of view.

I know Vanguard has a vested interest in promoting index investing so the arguments are far from biased. But that doesn't mean they aren't valid or true. The reasons above (plus others) are the reasons I have invested in index funds for over two decades now. And I don't plan on changing anytime soon.

How about you? What's your key financial investment these days?

Comments

[Nishanth muralidhar]

Well, that might be true for the US markets, but in the Indian stock markets where I have been investing for the past 10 years , the net returns for active mutual funds outperform the index funds by quite a wide margin, more than 10 per cent at least . The average return for my index fund has been 17% over the past 5 years and around 28% for my active stock mutual funds.The Indian market might have more inefficiencies or the index construction might be faulty, but as of now, active funds are the way to go in India , as well as , I suspect, other emerging markets

[Old Limey]

I was fortunate in several ways after I retired.

1) I started subscribing to a service that provided a huge database of mutual funds and analytical software that enabled one to pick out the current top performers amongst all of the available mutual funds. It took me several weeks to learn how to use the analytical tools provided to find the "hot" funds. This is where my engineering background and knowledge came in very useful.

2) Simultaneously with this the dot.com bubble was just getting started and I was soon able to find several mutual funds with very active managers that were doing a great job in finding the hot companies that were loading up on the stocks that were leading the way during this "once in my lifetime" bubble.

3) I had just retired with a portfolio valued at $320,000 at the end of 1992. I started buying the best 4 or 5 performers among these funds and rode them up all the way to the top. By the time the bubble finally burst I had got completely out and into the safety of bond funds and on March 6th. 2000 our portfolio peaked out at $3,300,000. The market index that was the big mover during this time was the Nasdaq 100. After that tenfold gain I became much more conservative and even though I have more than doubled our portfolio since then I now value safety, low volatility & the avoidance of stress most of all.

[Sarah]

"Instead, spend your time and effort working on growing your career -- something you can impact and which will yield much bigger dividends in the long term."

Best possible advice, really.

All of my investments are in index funds, with the exception of a little bit in one Vanguard managed fund (with an 0.25% fee). While I can't guarantee I'll never put a small speculative plunge, it sure as heck won't be in managed equities.

[YoungLimey]

I invested $1 in the stock market back in 1972. Now it is worth $12,567,897. The way I picked stocks is I closed my eyes and randomly pointed to the ticker symbol in the newspaper.

[Mark]

I know you're an index purist, FMF...but Morningstar just did an article today showing that cheap actively managed funds typically beat index funds. They showed that most of Vanguard's actively managed funds actually beat their peer index funds. They found similar, but not quite as good, results for other cheap actively managed funds. Granted, there aren't that many cheap actively funds that are out there, but they're there, most of them with Vanguard itself. The next cheapest fund family would be Dodge & Cox. Also, some people can get cheap "Institutional" share classes of mutual funds in their 401ks. For example, I have the cheap "R5" share class of American Funds EuroPacific Growth in my plan at work (.65% including admin. fee) as well as Growth Fund of America R5 (.49% including admin. fee), among others.

I don't knock index funds....but I do think it's worth paying a premium for active management if that premium is small, and while this is an admittedly riskier strategy since we can't know the future, it isn't an irrational one.

[Limey Junior]

Something tells me YoungLimey is not serious

[Lemon Limey]

So-- If Old Limey is Old, Young Limey is Young and Limey Junior is the "next generation"..... I guess I am the "tart" one.

[JC]

Vanguard index funds are an excellent way to go, however they're far from perfect. I take exception to #4. Market cap weighting, by definition, overweights the most expensive stocks and underweights the cheapest.

If costs are what matters, what prevents an investor from purchasing a basket of high quality blue chips directly and get their costs down to ZERO? This is a legitimate option for those with adequate portfolios, and is likely to outperform most funds because it has no expense drag whatsoever. I figure 30 or so DOW or Dividend Aristocrats should do the trick. Buy, hold & never sell.

[Strick]

I think because cost is based on portfolio value and not income/gains (and thus the cost percentages are based on the whole portfolio value) its extremely easy to underestimate the effect of these costs. I used to view a money manager who takes 1% to handle your portfolio costs 1% (generally an additional 1%, cause the other costs are still there)

Now I realize the 1% of the portfolio is not the number to think about, if I average 7%/year then he's taking one-seventh of my income/gains every year!

[Old Limey]

Strick
If you reach the point later in your life where tax exempt bonds become attractive you won't have to worry about a money manager siphoning off 1% or more of your gains.

I am getting an average of 4.935%/annum on a basket of 3,850 municipal bonds with maturities ranging from 2015 to 2050. Once you have bought a bond there are no fees whatsoever. If you also buy bonds issued by the state in which you live they are also free of state and federal taxes. Of course 4.935% is not going to make you rich but if all you are looking for is tax free income after you have retired they are quite attractive.

I am a Fidelity customer and they maintain a comprehensive inventory of muni bonds. I have very seldom needed to sell a bond but Fidelity has a fixed income department that can sell bonds for you if desired.
The other thing is that if you buy a bond below its par value of $1,000 you will receive $1,000/bond when they mature so there is also the possibility of picking up some capital gains.