True Believer

Are you a true believer? If you are not, it’s okay. Most people who invest in index funds do not fully understand them. You can still be a successful investor, but it would be even better if you were a true believer.

The word is getting out. Money is flowing from active mutual funds to passive index funds at an astounding rate. It’s no coincidence that Vanguard, the pioneer of index funds, has taken over the top spot as the largest fund company. Its S&P 500 index fund is the largest mutual fund. Investors are flocking to index funds and demanding that their employers offer them in their 401(k) package. Whether through their own research or on the advice of a friend, people are realizing that index funds are better than actively managed funds. However, I’m not sure they know the reason why they are considered to be better.

My clients use index funds to employ what I call a market-matching strategy, but some are not true believers. They have implemented an effective investment plan, but don’t fully comprehend it. They are putting their trust in me, which is perfectly fine, but I wish that they could really understand the undelaying logic of the plan. I think folks do “get it” during the planning stage, but they tend to forget over time. Concepts that initially seem very straightforward and logical can fade with the passage of time.

A true believer internalizes the ideas, thereby establishing a more solid foundation. As such, a true believer is less likely to panic and abandon the plan when times get rough. After all, if you “own everything” you can’t lose everything. A true believer will not fall prey to a sales pitch or get easily sidetracked. A true believer will stay the course and probably sleep better at night.

So how does a person reach this metaphysical state? I don’t know for sure, but I suspect that you will need to undertake some self-directed research. Since you might not be inclined to take such a step on your own, let me offer a brief explanation of why indexing works. You can decide for yourself if you want to go farther down the path to a higher consciousness and understanding.

An index fund provides the average rate of return for whatever sector of the financial markets it covers. For example, the Vanguard S&P 500 Index Fund (VFIAX) owns all 500 of the largest publically traded companies in the U. S. Some will do better than average and some will do worse, but the fund as a whole will match the average for the market. This means that if expenses are not a consideration, you are guaranteed to do better than one-half of all other investors. However, don’t think you’re settling for mediocrity. Once you consider expenses, you will do better than most others in the top half, because you will have much lower expenses. For instance, the Vanguard S&P 500 Index Fund has an expense ratio of 0.05 of 1%, which means expenses for a $100,000 investment are just $50 per year. The average large company domestic stock fund has an expense ratio of 1.4%, or $1,400 per year.

In contrast, active funds buy and sell largely from the same pool of these 500 stocks, but these active funds must overcome higher expenses. Why would you hire a fund manager unless he or she could beat the average and cover the higher expenses? By chance, a small percentage of fund managers will achieve a higher return even after expenses. The great majority will not beat the average by enough and therefore will underperform the index fund. My rule of thumb is that about 8 of 10 active funds will underperform an index fund with the same objective over an extended time period, such as ten years. For very long periods of time, the odds of success get even smaller. The simple act of choosing an index fund versus the typical managed fund instantly moves you to the head of the class. This works for various types of stock funds - not just large cap stocks – and is especially effective with bond funds.

Intuitively, you might want to search for the 2 of 10 fund managers that might beat the market. The problem with this approach is that it will typically be a different two each time. Identifying an index-beating fund in advance is nearly impossible and certainly not worth the time and effort. Even very skillful managers have difficulty beating the market, because they cannot see the future. All investors are looking at the same data and information. Professional investors frequently have the most sophisticated research and computer algorithms at their disposal, yet still can’t do it. The mutual fund landscape is littered with funds that were once 5-star funds according to Morningstar and are now 1-star or 2-star funds.

The Fidelity Magellan Fund (FMAGX) was once the largest fund in the world, because of its perennial 5-star status. It is now a 2-star fund, which has lagged the Vanguard S&P 500 Index Fund by an astounding 1.9% per year on average over the last 15 years. Similarly, the Janus Fund (JANSX) has fallen from 5-stars to 3-stars (and not too long ago it was 1-star). It has underperformed by 1.26% per year on average for 15 years.

Respectively, the operating expense ratios of these funds are 0.83% and 0.84%, which are lower than the average stock fund but much higher than the 0.05% for the corresponding index fund. When I looked up the performance, I expected to see an under-performance about equal to the difference in cost, which is the typical case for most active funds. Surprisingly, the shortfall was even greater than the cost difference. This means that the stock picking of the two funds was even below average irrespective of expenses!

You might think that I have cherry picked these results and to be honest - I have. I’ve done so to make an important point. These are the flagship funds of two of the best known mutual fund companies. They can choose from an extensive line-up of in-house talent or go outside to hire anyone to manage these funds. Even so, they have not matched the performance of the passive index fund. What chance do you have of finding the next great managed mutual fund?

I wasn’t always a true believer. I’ve used some index funds for as long as I can remember, but it wasn’t until about eleven years ago that I converted from active to passive investment. Many others have also converted to indexing, but I can’t think of anyone who has reverted back to active management. Warning: once you have internalized this concept, you will never want to go back!

It’s almost like the episode of Seinfeld when Jerry projects what George’s life will be like after his parents move to Florida and creates a “buffer zone” for him, Jerry Seinfeld said, “You have no idea how your life is gonna improve as a result of this. Food tastes better. The air seems fresher. You'll have more energy and self-confidence than you ever dreamed of.”

Okay, so maybe the food won’t taste better, but I believe that you will have a greater peace of mind and more confidence as an investor if you are a true believer. You won’t have to worry about being gouged by excessive fees, poor fund manager performance, or a host of other issues that characterize active management. You will also have more time and energy for more enjoyable pursuits. Of course, you can achieve nearly the same result based solely on my recommendations, but I can tell you from personal experience, it really helps to be a true believer.