Comments on: Don’t Just Buy Index Funds

By: Kevin A

Kevin A — Wed, 14 Mar 2007 23:06:19 +0000

Jeremy,
“Most mutual funds have a specific investment objective. Large-cap growth, small-cap value, large blend, emerging markets, income, high yield bonds, etc. All of these funds typically focus on one investment style or asset category, which clearly will not beat the market as a whole all the time.”
“So I think it is a poor argument to simply say that index funds are better because they often beat actively managed funds because almost all actively managed funds are not meant to be a sole representation for someone’s portfolio, but part of a greater asset allocation. It is really comparing apples to oranges.”

I stopped reading arguments after this one, so sorry if someone has already addressed this, but…

This is a ludacris statement! When you invest, you want to maximize the amount of your return. When you make long term investments, you want to maximize the amount of your long term investment.

So who cares if your mutual fund has a small-cap growth strategy, or a large-cap value etc. You don’t care what a mutual funds strategy is to make money, you care about how much money it makes!

Perhaps if there was a way to make things “safer” than the market would you accept a lower return. Whether a mutual fund is really “safer” than the market is at best, AT BEST, questionable.

So, we are dealing with risk and return. Mutual funds generally have higher risks (Due to less diversification, or, at least less than investing in an entire index of stocks) and lower returns (Due to mangement expenses). They aren’t apples and oranges, it is a fair statement to make say that most mutual funds do not outpreform the market.

By: Tristan Yates

Tristan Yates — Wed, 07 Mar 2007 01:42:21 +0000

Indexing is the only investment strategy backed up by 80+ years of research and five nobel prize winners. Specifically, indexing with a heavier weighting on small-caps and value stocks. If you have mined the University of Chicago’s historical data on securities pricing and uncovered an additional factor that explains stock performance, please publish it and claim your own Nobel prize in economics.

By: moominoid

moominoid — Sat, 27 Jan 2007 01:51:11 +0000

I don’t invest in index funds – only use them as trading instruments – ETFs and futures. For people not interested in investing a diversified portfolio of index funds probably makes a lot of sense. For me, this would be way too boring as I love investing and trading. So I’m never going to stick with it.

By: EF

EF — Wed, 24 Jan 2007 20:52:31 +0000

Good post, but it doesn’t address the main reasons people invest in index funds: they have neither the time or inclination to do research, etc. Plus (apologies for stating the obvious … but it’s often overlooked) NO fund is without risk — every prospectus I’ve ever gotten has said so.

By: Fazal Majid

Fazal Majid — Wed, 24 Jan 2007 16:23:57 +0000

There is one major problem with index funds: the reason the costs are so low is that fund managers hardly do any work other than periodically reshuffling the portfolio as index composition changes. Among other things, they are not active shareholders. In the best of cases, they will simply vote along with corporate governance advisers like Institutional Shareholder Services.

Probably one of the biggest downward pressures on returns is the tendency of entrenched managers to loot from shareholders by awarding themselves huge salaries and stock option packages thanks to lax corporate governance. If an when index funds become the majority of holdings, there will be little countervailing force to prevent them from doing so. Not that actively managed mutual funds are any better in this regard.

By: Debt Hater

Debt Hater — Mon, 22 Jan 2007 17:06:43 +0000

I love these Devil’s Advocate posts!
I am not a hard core investor because I still need to get out of debt and I don’t know enough to make smart decisions.
That said, half of my 401k contributions goes into an S&P 500 index fund and about 30% goes into aggressive international funds. Those are the two best performing components of my 401k so far. I might move more money into the international fund, but I must admit that the index fund makes me feel secure. I feel like I’ll never do worse than the market with the index fund. And yes, I’m too lazy to do much more research than this right now!

By: Paul

Paul — Fri, 19 Jan 2007 13:13:10 +0000

I think too much attention is paid to investing in stocks. And individual stocks are extremely risky in my opinion. You can as easily end up with a Worldcom or Enron as you do a Microsoft. Unless you are a high roller in the company you invest in, you can never know the true situation. Companies fail at a very high rate. Even great companies like AT&T once was, can go down. For my money, buy an index fund and forget it. I've written an alternative strategy to investing here link

By: Ashley Barton

Ashley Barton — Thu, 18 Jan 2007 17:52:28 +0000

I know this comment will get a fair amount of grief from the indexing crowd, but I always smirk when I hear or read statements like “a majority of mutual funds underperform the market”. Don’t get me wrong, I agree with the facts of the statement, but what bothers me is the implication that majority in this case is something close to 100% which it is not. While the number is on the high side (appx. 80%, I believe), it isn’t too difficult to identify most of these underperforming funds. This statement also indicates that there are 20% of actively managed funds that outperform the market. When I refer to funds that outperform the market, I’m not talking about over the past couple of years, I’m talking about funds who have annualized expense-adjusted returns better than the market for 1, 3, 5 and 10 year time periods and have had the same fund manager for over 10 years. Using the MSN Money Fund Screener, there are 143 no load funds that have outperformed the Vanguard Total Stock Market Index (a better representation of the market than S&P 500) using this criteria, with more than one fund in each of the nine market segments (growth, blend, value & large-cap, mid-cap, small-cap).

I know there are those who say “past performance doesn’t indicate future returns”, but past performance does indicate future potential. To make an analogy, if I owned a baseball team and were signing a new player and had the choice between the average .275 hitter or a .310 hitter with all other aspects equal, I’d be inclined to sign the .310 hitter. While there is no guarantee that the .310 hitter will continue to bat better than .275, I think his chance are better since he’s shown he can do it in the past. I think the same can be said of mutual fund managers. When you buy a mutual fund you are buying a manager, not a fund name. This is why Janus funds, which did great in the 90’s, have fallen off in the recent past. Most of the managers of the Janus funds in the 90’s have left those funds and either gone elsewhere or started their own fund or fund company.

Obviously owning an actively managed portfolio requires more work than an index portfolio. I check up on my portfolio quarterly to ensure that my asset allocation is correct, and for any significant changes in my funds progress in relationship with the market. I wouldn’t suggest it to everyone, there is fair amount of diligence involved. Although I think with any portfolio the investor should be diligent. For some reason a lot of investors seem to think the term “buy and hold” really means “buy, hold and forget”. Every investor should be adjusting their asset allocation as it relates to their risk tolerance as time passes. I don’t think anyone would suggest that the asset allocation for someone aged 35 should be identical for someone aged 45 or 50 with like circumstances.

By: jim

jim — Thu, 18 Jan 2007 12:56:24 +0000

I agree Angela, it’s a very weak position, but I believe the points above are still worth keeping in mind. Sometimes with these DA posts, the arguments will be a little tenuous but still worth taking a look at (I hope!).

By: Angela

Angela — Thu, 18 Jan 2007 12:45:52 +0000

Yep, its kind of a weak position, as even when you’re saying that you shouldn’t just invest in a single index fund, one of the solutions given is to invest in more (different) index funds. So I’m pretty much sold.

What’s the alternative? an actively managed fund that may or may not produce better returns in the future than the index fund or investing in individual companies/bonds/real estate (being your own fund manager).

By: CPA1298

CPA1298 — Thu, 18 Jan 2007 02:15:52 +0000

Jim – this one is definately controversial, but I think the Devil’s Advocate position is hard to win. Simply, index funds are the logical choice. I don’t need to list the reasons. If a person did simply invest in the S&P all their lives, they would have low cost exposure to the 500 largest companies in the country, which are diversified internationally due to their global operations. I think the weakness of the Devil’s Advocate position shows how strong indexing really is.

Good effort. I’m still waiting for the 401(k) Devil’s Advocate

By: mapgirl

mapgirl — Wed, 17 Jan 2007 18:46:10 +0000

“In this case, a lot of folks advise that you should just invest in some index funds and be done with it.”

That’s just sheer ineptitude and laziness! GAH! Our generational apathy extends to our finances… Man, what a sorry lot we are.

(I keep hearing that song from Bye Bye Birdie, “Kids! I don’t know what’s wrong with these kids today!” You know the one.)

By: jim

jim — Wed, 17 Jan 2007 17:52:01 +0000

mapgirl – It’s a devil’s advocate post, which seeks just to shine a light on the reasons why one shouldn’t follow conventional wisdom or common advice. In this case, a lot of folks advise that you should just invest in some index funds and be done with it.

Personally, I love index funds because they’re cheap, perform well, and they’re low maintenance. Maybe I need to put a devil icon or something…

By: mapgirl

mapgirl — Wed, 17 Jan 2007 17:18:39 +0000

“Show me an individual investor who does a better job of managing risk than an index fund, or a basket of index funds, and I’ll show you a glow-in-the-dark pig that does gymnastics.” – Samerwriter

GREAT QUOTE! It’s true. Very few CFA’s even beat the market over the long run.

Jim, I think you do your readers a slight disservice with this post. You don’t present any of the statistical reasons about why index funds are good investments for the lazy. They are very solid investment choices because they involve little trading activity so most fees are low for index based funds. They are Buy & Hold funds, which is how Warren Buffett makes his money. He never sells. The thing also to keep in mind is that over any 20 year period in the market’s history, the market has been the best possible investment, beating out gold, currency, or real estate. (Love Jeremy Siegel’s work here.)

Now, ask me a question, do I hold indexed funds? Yes I do. But as a novice student of investing, I also know that I’m not into CAPM research to find better investments either. I keep a few different funds in my portfolio with a good chunk of it in an S&P500 index fund. But I also have diversified into an REIT fund, small and mid cap funds, and an international fund to broaden out my risk. I plan to hold onto all of them for a good long time. The reason I have branched out beyond index funds are threefold. 1) I like to spread out my risk over a variety of investments. 2) I think I can beat the market slightly if I have one or two investments that are spectacular. I’m looking for an overall ROI that’s only 1-3% greater than the market, so I don’t need a whole lot of winers, just a few. 3) I like to spread out my risk. While I’m willing to take on a lot of risk with an investment portfolio that is large stock-based, I don’t think it’s wise to put all my faith into the US stock market. It fluctuates, which is why I like to balance my risk out with international funds, etc.

Let me stress however, that I don’t really do any research. VERY LITTLE. Periodically I look at returns, but rarely do they move me to make a trade or rebalance. Things are just fine.

Oh wait. I see. I guess I do agree with you Jim. No, you shouldn’t make index funds your only investment.

By: Jeremy

Jeremy — Wed, 17 Jan 2007 04:11:56 +0000

Travelin’ Man, that brings up a good point about actively managed funds. You’re right, one of the common things you read is that most actively managed funds don’t beat “the market”. While this is true, the main thing to consider is that most funds aren’t trying to mimic or beat the market. If they try to mimic the market, all they are is an index.

Most mutual funds have a specific investment objective. Large-cap growth, small-cap value, large blend, emerging markets, income, high yield bonds, etc. All of these funds typically focus on one investment style or asset category, which clearly will not beat the market as a whole all the time.

So I think it is a poor argument to simply say that index funds are better because they often beat actively managed funds because almost all actively managed funds are not meant to be a sole representation for someone’s portfolio, but part of a greater asset allocation. It is really comparing apples to oranges.

Again, index funds are the best “bang for your buck” core holdings, but still they are simply just one tool in creating a diversified portfolio that minimizes risk and maximizes returns. If someone were to only purchase one fund and rely on that for 30 years of growth, yes they would probably be better off going into an S&P index as opposed to some random large-cap fund or sector fund, but creating an asset mix with various index funds or actively managed funds will likely provide equal returns with reduced volatility, which I think is what people should strive for. Maximum return with the least amount of volatility.