8. The Power Of An Index Fund
The logic of adopting an equity investment strategy focused on at least in part on indexing seems almost overpowering. There is every reason to assume that in the future index funds will be equally successful in surpassing the long-term results of most professional advisers. (Bogle, p.177)
We have previously shown that the authors believe that the average investor should invest in the market. But why is an index fund such a powerful tool?
Why is an index instrument so powerful?
The average investor will get average gross results in the same way the the average trader would also get average gross results, and the average fund manager would get average gross results. We are, after all, all part of the same market. What then, if in the end you will just reach market average, makes an index fund better than an actively managed fund?
Financial scholars who have been studying mutual fund performance for the last half century are unanimous upon a few points (Graham, p.243)
1) The average fund does not pick stocks well enough to overcome the costs of researching and trading them.
2) The higher a funds expenses, the lower its return.
3) The more frequently fund trades its stocks, the less it tends to earn.
The answer is simple in itself. The costs of hiring the active fund managers are so large that they eat up all the profits. An index fund, which is average, can be handled passively through algorithms. That removes fees. The inability of fund managers to stay ahead to such an extent that their fee is covered, leads to small underperformance every year which eventually grows to big differences due to the compound effect over time.
Low fees and costs
Low fees and costs can be described as stacking the odds in your favour. Your security performance is called the gross return. What the investor gets back in their account is the gross return minus fees and costs, what is known as net return. Imagine that the market would rise by an average of 8% every year. This would be the average gross return of any investment made. If you had two funds, and one had fees of 2% vs one had fees of 0.3%, the actual return to you as an investor is 6% vs 7.7%. Due to the fact that a passively managed index fund invests through a formula, there is much less work required compared to an actively managed fund. There are no analysts who pour through their reports, no inspections on site, no time spent on calls to management.
In addition, holding a market capitalisation weighted index fund minimises trading. The securities position in the portfolio will naturally flex as the prices move. There is no need for frequent rebalancing to incur trading costs. In addition, infrequent trading could also (depending on country) enable the fund to reach another tax bracket (in the US, long term capital gains vs. short term capital gains) which further decreases cost.
These two factors enables index funds to operate without creating a substantial fee and cost structure.
Regression to the mean
Returns from both stocks and actively managed funds seems to regress to the average because they are organisations competing in an ever competitive environment (Bogle, p.20). Bogle presents a few data points which illustrates the case (Bogle, p.88–89)
- The average top 20 fund in any one year between 1982 to 1992, has an average rank the following year of 284 (with the mean at 341).
- The average top 20 fund in one decade between 1972 and 1982 had a rank of 142 out of 309 the following decade. It returned 14.3% compared to the average fund with a return of 13.1%. The S&P, however, returned 16.2%
- A company in 1986 took the best all star fund managers and had them create a fund for six years, until its close in 1992. The S&P delivered 13.9%, and the all star team 12.8%. It is as if a randomly selected team of average high school and college football players had beaten the NFL Champions with 14–13.
Compounded effect
The low fees result in much greater yield over time due to compounding effect. As shown below, every percentage matters. A 2% increase over time results in great differences when the investment horizon spans enough time, growing to almost double size in three decades. Every 0.5% increase in annualised returns yields a total of 17% increased return after 35 years!
Impact
Low costs for passively managed funds, the implausibility of actively managed funds to outperform the market with enough margin, and the magic of compunded effect, enables the index funds to come out as a clear victor after decades of performance.
Looking back from December 31 2002, how many US stock funds outperformed vanguard 500 index fund? (Graham, 249)
One year, 1186 out of 2423, (48.9%)
Three years, 1157 out of 1944 (59.5%)
Five years 768 out of 1494 (51.4%)
Ten years 227 out of 728 (31.2%)
Fifteen years 125 out of 445 (28.1)
Twenty years, 37 out of 248, (14.9%)
Notice that these results are skewed by survivorship bias, i.e. it does not take into account all the funds that have shut down in the mean time.
Summary
In the stock market the index fund has shown itself to be of unquestionable performance over time. The inability of professional money managers to consistently outperform an index fund adds up over time due to compound interest. As such, almost all actively managed funds have proven themselves unable to be a good option to investing in the market. Next up: How to select an index fund.
