3 Lessons for Index Funds

Due to index funds' portfolios do not exactly match the indexes', on occasion they will sneak past their benchmarks

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Index funds did not take the mutual fund industry by storm. Five years after its debut, Vanguard 500 Index had $90 million in assets, which made it a modest sales success by the standards of its time, but scarcely the vanguard of a revolution. Ninety million dollars was also the total of the industry's indexed assets, as neither Vanguard nor a rival had launched a second index fund.

The initial marketing was stymied by the effective, but misguided, claim made by indexing's early critics--that index funds always lose. Every active fund has the chance to beat its costless benchmark. However, index funds are guaranteed to trail. Because they mimic the costless benchmark but then add expenses (and trading costs), they inevitably fail. They lag their benchmarks, every year.

This criticism is largely true, although not entirely. Expenses do indeed drag down the returns of index funds when compared with the theoretical indexes that they track. However, as costs for the big index funds are slight and there is some fluctuation because the funds' portfolios do not exactly match the indexes', on occasion such funds will sneak past their benchmarks.

This may all seem rather obvious; today, it is commonly recognized that for the major index funds, the advantages of being having lower costs and being fully, consistently invested outweigh the minor imperfections that are introduced by implementing the strategy. However, the lessons are timeless and, I think, not as widely known.

1) Much investment "common sense" is not

By definition, index funds are losers, since they can't beat the indexes that they track. You can't beat the averages by being average. You get what you pay for. Automated strategies work great during bear markets, but when the times get tough, you need a human hand. All common sense, right?

Not so. Yes, those sentences each sound reasonable upon their first hearing, and if not examined too closely. I have heard each of them delivered at investment conferences, multiple times, generally with great success. The audience nodded appreciatively; there were few if any murmurs in protest, and no awkward questions posed to the speakers.

Yet each bromide is wrong. As we saw, index funds are indeed by definition losers, but that definition happens to be unimportant. That something happens to be true doesn't make it significant. As for the notion that index funds can't beat the average by being average, that claim relies on the listener misunderstanding the facts. Index funds are average (or close to) before expenses are subtracted, but they are above average afterward.

As Jack Bogle likes to point out, investments differ from other consumer purchases in that you don't get what you pay for. Instead, you get what you don't pay for, because every penny of expenses comes straight from a fund's returns. The bumper-sticker slogan is exactly 100% wrong. Finally, while it seems reasonable that tough times require a human hand, there's no evidence from multiple bear markets that investment managers can identify bear markets before they occur and profit from that knowledge.

2) Expedience is a powerful force

All right, you probably knew that part, too. Before Caesar and Christ were born, Demosthenes wrote that the easiest mistake is self-deceit, because man believes what he wishes to be true. That belief is particularly strong when it pays in cash. Active portfolio managers are, on the whole, very bright people, and probably more ethical than most employees in most industries (my readers, of course, being happy exceptions). But they are severely compromised when discussing the demerits of index strategies.

3) Misperceptions can and do persist for a long time

It required 80 years for the effect of mutual fund expenses to be fully appreciated. Mutual funds first came to prominence in the 1920s, but it wasn't until the mid-2000s that low-cost funds consistently outsold high-cost funds. (Today, the cost argument has won completely, as almost every new fund share carries significantly below-average expenses.) Investors learned the benefits of indexing more rapidly, but even indexing took 20 years to move from the fringe to the mainstream.

In short, the mutual fund industry remains something of a story business. It is less so than most other financial offerings, such as hedge funds or insurance products, which are less transparent. It is also less so than in the past, thanks to decades' worth of evidence and extensive academic (and industry) research. But it remains an industry where stories are told--stories that sound convincing on the surface, and that may well convince those who tell them, but which cannot withstand close analysis.

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About Author

John Rekenthaler, CFA  John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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