Index Funds — overwhelming evidence

Mutual funds are the practical way to buy and hold diversified collections of stocks, but there are different types of mutual funds: actively-managed funds and passively-managed funds. The focus of this page is to explain why passively-managed funds, or index funds, are so important to your investing success. Contents:

Select Video Tutorials about Index Funds

and about Target Date Funds that use Index Funds


All are excellent videos. The transcripts can help you make the best use of your time.
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Commonly asked questions about Index Funds.


1  Questions answered in video about passive investing using index funds:

2  Questions answered in video Passive Investing with Index Funds

3  Questions answered in video interview with John Bogle about Vanguard and index funds:

4  Questions answered in video How to Win the Loser’s Game

5  Questions answered in other videos about Index Funds

6  Questions answered in videos about Target Date Retirement Funds

Answers to questions about passive investing using index funds


Why passive investing? What are index funds?

See relevant section of transcript and video: Passive Investing With Index Funds

There is an enormous set of historic data and academic evidence that investors can earn the best returns by owning the whole market at the lowest possible cost. The practical way to do this is with index funds. For example, the S&P 500 is an index fund that owns stock in the 500 largest U.S. companies. By owning a share of the fund you own a portion of all 500 companies.

An index fund is a special form of mutual fund—which is the easy way to own a large collection of stocks or bonds. The distinguishing attribute of an index fund is that they can be very low cost. They do not have managers that are speculating in an attempt to outperform the market.

The low costs are important because of the power of compounding. Paying 0.2% costs (typical for a Vanguard investor) for 30 years means that you lose 6% of your investment to costs. Paying 1.2% costs (common for many investors) means that you lose 30% to costs.

How many index funds do I need to own?

See relevant section of transcript and video: John Bogle on Vanguard Index Funds

Well you can certainly do it with one, and that would be something like the Vanguard Balance Index Fund, it’s 60% total stock market, 40 % total bond market, both USA, and that’s fine. The nuances have to do with getting an appropriate stock/bond ratio—or matching your overall asset allocation with the level of investment risk that you can live with. Some funds automatically become gradually more conservative as you age. At Vanguard, these type of funds are called Target Retirement Funds.

Sometimes investors can reduce their annual tax costs by choosing to locate stock funds and bond funds in taxable and tax-advantaged accounts. This topic is referred to as “tax efficiency”.

Is it OK to use a balanced fund that has both stocks and bonds?

This is fine for getting started if the cost (expense ratio) is not greater than the costs of a dedicated stock fund and a dedicated bond fund. The advantage is simplicity. The disadvantage is slightly less control if, for instance, you wanted to keep stocks in your taxable account and a combination of stocks and bonds in a tax-advantaged account.

What if I want better than average returns?

See also: Index Investing Part 7: Is There a Scheme Better Than Holding The Market Index?

First, it is a serious misunderstanding to believe that achieving the market return is “only mediocre” and less than your neighbors—it is quite the opposite. Achieving the market average is difficult to achieve and the majority of your neighbors do not. Less than 1% of investment fund managers can beat the market in the long run. The reason the majority fail is because of their costs.

However, it is still true that you can increase your expected return by assuming more investment risk. You do this not by paying a manager to try and pick tomorrow’s winners, but rather by adding some riskier asset classes. For example, if the stock portion of your portfolio is “the total stock market index”, you might allocate 20% of this to a “small company stock index fund”. But it would not be fair to compare your new portfolio with the average stock market return, because your new portfolio has both more investment risk and higher expected return.

Why is Vanguard special?

Unlike other investment fund companies, Vanguard is owned by, and thus run entirely for the benefit of, its investors. Partly as a result, Vanguard has very low costs (see Vanguard FAQ).

From Vanguard’s Why invest with us webpage:

Your interests are the only interests we serve Most investment firms are either publicly traded or privately owned. Vanguard is different: We’re client-owned. Helping our investors achieve their goals is literally our sole reason for existence. With no other parties to answer to and therefore no conflicting loyalties, we make every decision—like keeping investing costs as low as possible—with only your needs in mind.

Questions from Passive Investing with Index Funds


Don’t the best fund managers beat the market average?

See also: Part 1: The Out-performance Myth About Beating The Stock Market

The great out-performance myth is that you can simply hire experts with talented research staffs and big computers to get better than average returns. The reality is that this myth is sold really well: lots of advertising and compelling pitches. But after costs, nearly all fail to achieve the market average. In one 25 year study only 9 of 355 active funds beat the market average more than 2% —and 2% is a pretty typical approximation of the cost to investors. Think that sounds promising? The problem is that you cannot choose the winners in advance. Every year produces a fresh crop of winners which feeds into their advertising. Being a consistent winner is nearly impossible.

This website is dedicated to helping ordinary investors not only see that passive investing with index funds in the winning strategy, but also realize that investing is remarkably simple—not necessarily easy, but simple—straight forward.

Don’t the best fund managers produce returns higher than their costs?

See also: Part 2: The Cost of Investing

All the evidence shows otherwise. But part of the problem is the costs aren’t glaringly obvious. Part of their cost are—their annual operating costs are required to be publicized, which they do under the heading “expense ratio“.  Ok, we’re quick learners so we can deal with that, but costs are not so obvious—like transactions costs. Actively managed funds do a lot of trading and this can be inferred, if you look under hood, under the heading “turnover ratio”. High turnover also produces a tax consequence in taxable accounts. Ultimately you have to sum the fund costs, with any account costs, and typically you’ll find thy extract in the range of two or three percent of their assets per years from their clients. Amazingly, William Bernstein points out, if you do that over a period of 30 or 40 years, eventually your broker owns more of your assets than you do!

How can passive investing beat the market without doing anything?

See also: Part 3. A Better Alternative To Trying To Beat The Market

Set aside the notion of “beating the market”. First and foremost, try to capture the total market return—that is what active investing fails to do. Passive investing with index funds can do this because these funds can track a broad market index for a very low cost (less than 0.1% per year).

The Total Stock Market Portfolio will return the market average because that is what it is. Strive for this and you’ll be doing better than all your neighbors. But it is still possible to beat this market average with a different portfolio—but now we are comparing apples and oranges. You could choose to instead own a broad market index of small company stocks. Such a portfolio would be more volatile than the total stock market, but also have a higher expected return.  Think about apples and oranges if somebody tries to sell you a fund that is performing better than the S&P 500 but might be comprised of riskier stocks. The correct thing to do would be to compare it to an appropriate benchmark index fund, but they will make this hard to do.

What is the best way to diversify?

See also: Part 4: Ultimate Diversification Also Reduces Your Investment Volatility

Two important concepts: First, you need to own both stocks and bonds and the very important decision here is how much bonds to own. You want to learn how to use bonds to control your overall risk and to take your risk exposure only on the stock side of your portfolio. Second, your goal with stocks is to be very broadly diversified at the lowest possible cost. You can accomplish with perhaps as few as a single mutual fund.

Can passive investing take the stress out of investing?

See also: Part 5: A Healthier Way To Invest

We are bombarded by messages that tempt us to do something different with our investments. The most valuable thing to learn is how investing can be remarkably simple—straight forward. If you can create a plan, preferably written, that you can commit to sticking to “come hell or high water” then you can more easily avoid bad investor behaviors. It’s all about lifestyle choice, but we can accomplish our long-term goals without having to think about, and worry about, money all the time. If you can regularly invest over time, and rebalance based on percentages (e.g. own your age in bonds) then you can keep the emotion out of investing.

Why do most people use active management if passive is better?

See also: Part 6: Hooked on Active Investing

Largely it is because we are sold this stuff though advertising and the media (which gets funded by that advertising).

But it is also because we are not paying attention. Retirement is so far away that such details don’t seem important. So we don’t know what the costs add up to.

And also, it is because it is counter-intuitive. For most everything else in our lives, we get something better by paying more. It even seems logical that we could get better investment returns by hiring a firm with the very best and brightest experts with research staffs and fast computers.  But with investing it is the opposite. The more you pay, the less you earn. To put it bluntly: the job of a stock broker is to transfer the wealth of the client to themselves.

Will everyone ultimately become index investors?

See also: Part 7: The Tide is Turning To Much More Focus on Cost and Diversification

As long as there are some traders, then new information will get priced into the stock market. It doesn’t take much. There will always be people who are overconfident enough that they’ll try to beat the market.

What should ordinary investors do?

See also: Part 8: The Rational Choice Is A Passive Investment Portfolio

This is what Warren Buffett says about passive investing, “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.”

Questions to John Bogle about Vanguard and index funds


Index funds seem like common sense, were they once a “disruptive technology” ?

See relevant section of transcript and video: Vanguard Index Funds as a Disruptive Technology

Back when they were first introduced, active fund managers ridiculed index funds saying, “Our shareholders would never want a fund with average performance.” While this is probably literally true, smart investors know that their best chance of capturing the market return is passive investing with index funds. Nearly all active investors achieve less after costs.

Do active traders make-up most of the market?

See also: We are all indexers—even the active traders.

Yes, there are about three active investors for every index investor. If active investors aren’t hoping to become the next Warren Buffett—or to win the lottery—they do cling to the notion that the smartest fund managers ought to do better than average, if only by not investing in the worst companies. There is no evidence to back this up. Investing is counter-intuitive in that: the less you pay in costs, the greater your long-term returns.

Has buy and hold become an old-fashioned idea?

See also: What happened to long-term investing?

Buy and hold is still the mantra of common sense investors. But the vast majority are persuaded—by salesmen and the news media—that they can actively pick out tomorrow’s winners and avoid trouble by timing-the-market. All the evidence shows that they’ll even do worse than their neighbors who buy boring index funds and then quietly ignore them.

Is there anything good about trading stocks?

See also: Is there anything good about trading stocks?

Bogle answers no. But here Prof Cochran explains why in a compelling example.

What should we think of a salesman who says he can beat the market?

See also: A paid salesman can always beat the index fund.

Every year, half the funds beat the market (before costs!) and half do not. And every year the winners are a different set that cannot be predicted in advance. So it is the easiest thing in the world to point to one of last year’s winners and infer that it was due to superior management.

Are there any good fund managers?

See also: Good managers are in the business of investment management, and not in the business of marketing.

Admirable fund managers are the ones that are in the business of investment management, and not in the business of marketing.

What happens behind the scene of an index fund?

See also: Behind the scenes of Vanguard index funds? Is it 5 robots, 3 monkeys and a bunch of data?

Just like any sport, it is relatively easy to do fairly well but very difficult to excel.  So too with managing an index fund to closely track a market index at the lowest possible cost.

Why capitalization-weighted funds? Are there better ways of indexing?

See also: Is a cap-weighted index fund bad? Are there better indexing schemes?

Bogle explains in plain language why cap-weighting is ultimately best because it represents the market. I personally understand this point best when I think about the optimum portfolio in  Modern Portfolio Theory is the sum of all available securities—which is by definition a market-value weighted (or, cap-weighted) portfolio.

How many index mutual funds should an individual own?

See also: How many index mutual funds should an individual own? What’s too many? What’s too few?

One is fine. And since mutual funds have a minimum investment (e.g. $3,000), starting with a single balanced fund is recommended. But even when your investments grow very large, you can own the whole market with very few funds. A common situation might be to have a stock funds in a taxable account, and both a stock and bond fund in a tax-advantaged retirement account.

How much bonds to own? Does Social Security affect this?

See also: Social Security and how much bonds to own?

Bogle stresses that it is important to think about cash flow and your investment risk, but once you start Social Security a large portion of your income becomes very reliable.

Some people don’t want to manage their money. Are financial advisors OK for them?

See also: What about financial advisors for those that don’t want to do it themselves?

Investing is very simple—conceptually simple. It’s not easy, but that is largely because of the messages that bombard us from marketing and the news media—information to persuade us to hire professional help. Sure, some people will always need help, but they need to find a way to get help for a fair price.

How much should you pay for financial advice?

See also: How much should you pay for financial advice? (some eye-opening arithmetic!)

Follow this link and Bogle will convince you that it is really worth learning to do yourself. I am also captivated by William Bernstein’s classic book, The Four Pillars of Investing, where (p.199) he shows very easy it is for your money manager to eventually have more of your total wealth than you do!

Does capitalism work well with money managers?

See also: Does capitalism mix with the fiduciary duty of managing other people’s money?

Well no, there is an obvious conflict of interest here. Here’s a link to the end of the series Winning The Loser’s Game where the conclusion is about how the fund industry fails both individuals and society as a whole.

What are the two guarantees in the financial business?

See also: We have two guarantees in the financial business.

The first, “If you buy the index fund, you will get the market return.”

The second, “If you don’t invest, you will get nothing.”

When is it appropriate for an individual to buy stocks?

See also: When is it appropriate for an individual to buy stocks?

Sometimes this occurs because employees have attractive stock purchase programs. Long-term employees need to be careful about getting too much risk concentrated in that one company. But individuals who wish to speculate for the game of it should keep this to less than 5% of their portfolio.

Surprise! Is investor behavior less of a problem for individuals trading stocks?

See also: Interestingly enough, there are no behaviorisms in the field of stocks generally.

It is clearer to see with individual stocks that for every single transaction: one party thinks the stock is overvalued while the other party thinks the stock is undervalued. Recognizing that trading stocks is, at best (before costs), a zero-sum game tend to tamp down irrational exuberance.

Hold forever, or when should we abandon stocks because of loss of faith in team?

See also: When to abandon stocks because loss of faith in team?

No team outperforms in the long-run.

Is there ever a situation where a good fund might be a load fund?

See also: Is there ever a situation where investor should be happy in a load fund?

No.

Do you expect a unified fiduciary standard in the future?

See also: Do you believe we will have a unified fiduciary standard or not?

This is a hugely profitable industry that can spend a lot of money to lobby for their interests. This hope is bleak, but people need to become educated.

What kind of company culture resulted in the Vanguard of today?

See also: The company culture that created Vanguard index funds

Bogle reflects back on the early years at Vanguard and makes them sound like the early years of many companies.

Questions from How to Win the Loser’s Game


Why do so many ordinary investors continue to buy actively managed investments?

See also: Index Investing Part 1: Are There Star Performers That Can Beat The Market?

The Loser’s Game is to actively invest with the belief that you can do better than the market average by selecting the right fund (i.e. fund manager).  Their marketing is good, but it is scandalous because they charge fees that might look like a small percentage, but it amounts to a large chunk of your return. So why do so many ordinary investors do this? Reasons include: (1) this is a hugely powerful and largely self-regulated industry, which lobbies hard to protect its interest, (2) it also spends a fortune on advertising, and (3) the financial media, which is largely funded by those advertisements, has an insatiable demand for stories, which the fund management companies are only too happy to provide.

What kind of fees and expenses am I paying? What’s a good price?

See also: Index Investing Part 2: Effect of Investment Management Fees

In the United States the funds are required to publicize their annual operating expenses which they do under the obscure name: expense ratio. This is easy to find and compare. Funds also have transaction costs which are not specifically called out, but the funds so publicize turnover and actively managed funds have much higher turnover, so implicitly much higher transaction costs. Those transactions also cost investors additionally in taxable accounts by generating capital gains that would otherwise be deferred. Prof. Eugene Fama says, “If you’re paying management fees, the cumulative effect of that, given the way compounding works, is enormous.”

Why do you say that index investing is superior?

See also: Index Investing Part 3: The Dismal performance of Actively-Managed Funds

Every year perhaps 30% of the actively-managed funds beat the market average after costs are considered. The problem is, every year it is a different 30% and you cannot predict the winners in advance. The result is that in the very long run (which your investment lifetime is) probably about 1% of managers beat the market. The reason that index investing is superior is because you get to keep what you don’t give away as fees and expenses. It is counter-intuitive. In most parts of our lives, if we pay more we expect to get more. But with investing, if we pay more we get less.

Can you trust the academic research about index investing?

See also: Index Investing Part 4: What the Academic Evidence Says

There is a wealth of empirical research of this subject that investors can draw on. This video summarizes key principles by a long line of academics including Nobel prize-winners. In short, great findings were made possible by the computer more than half-century ago and “no one has been able to disprove them.”

What is the optimum index fund investment portfolio?

See also: Index Investing Part 5: What is The Optimum Index Fund Portfolio?

Prof. William Sharp is one of several Nobel Prize-winners for this topic that showed that the optimum portfolio is also the Market Portfolio, which every available security. So if you own 1% of the money in the market, your portfolio would have 1% of each stock in the market and 1% of each bond in the market. The Market Portfolio, by definition, is weighted by market capitalization value, so market index funds that try to track the same holdings also use a capitalization weighting strategy.

Another way to word this comes from Markowitz, another Nobel Prize-winner, who showed that if any security is not 100% correlated to your portfolio, then the risk/return characteristics of your portfolio will be improved by adding some portion of that new security.

Finally, it is important to remember that the Market Portfolio will achieve the Market Return.  You can still increase your expected return if you are willing to hold more market risk. See discussion on “tilting” below.

What is the reason index investing is the winning strategy?

See also: Index Investing Part 6: The Winning Strategy Boils Down To Simple Mathematics

It is very simply put: (Gross Return) minus (Costs) = (Net Return)

When you consider all investors, they get the market return. But it is also true that when you consider all active fund managers, they get the market return. This is because all passive investors get the market return, and the Market is simply the sum of passive and active investors.

And finally, every year half of the active fund managers beat the other half of the active fund managers. But it is impossible to pick them in advance.

Is there an indexing scheme better than proportional to market value?

See also: Index Investing Part 7: Is Anything Better Than Capitalization-Weighted Index Funds?

No. Perhaps the easy way to understand why is to see that in the very long run, the Market has to return the Market Return. If you choose any other scheme that would beat this, then there would be an alternate scheme that would lose by the same amount. In the end, an alternate indexing scheme is yet another actively managed fund.

Can you tilt a portfolio towards a risk factor for higher expected returns?

See also: Index Investing Part 8: Can You Tilt a Portfolio To Achieve Higher Returns?

There are a few factors that are correlated to both higher volatility and higher expected returns. Small company stocks would be an example of this. So if an investor felt that greater investment risk was acceptable they could also enjoy higher expected return.

How does investor behavior play a part in this?

See also: Index Investing Part 9: How Does Investor Behavior Impact Returns?

The market is out there trying to temp you every day. They want you to “do something, do something, do something.” The media is definitely a bad influence on investors. But in a nutshell, the secret to winning the loser’s game is first, choose a strategy that’s based on evidence—one that is designed to capture the returns of the whole market—and then balance this with bonds to achieve your desired level of risk. The second part of the secret is to stick to your strategy through thick and thin. Rebalance your ratio of stocks/bonds to maintain your desired level of risk, but most importantly: stay the course.

Is the fund management industry serving society? or failing society?

See also: Index Investing Part 10: The Investment Industry Is Failing Individuals and Society As A Whole.

Sadly, many smart people have entered this profession not to help society but to accumulate wealth. Of course, they may individually think they are helping, but as a collection they have great expertise in separating us from a very big chuck of our money. MoneyWeek magazine says the fund management industry needs huge reform. In fact, investing is remarkably simple—not necessarily easy, but simple—straight forward.  It doesn’t need so many different products. It doesn’t need so much differentiation. It doesn’t need quite so many people. And it doesn’t need to be so expensive.

Questions from other videos about Index Funds


What is index fund investing?

See also: What is Index Fund Investing? (video)

Vanguard made a very short video (above) describing how, traditionally, mutual funds hired an expert portfolio manager and it was his job to figure out what the best securities to go uot and buy. Index funds don’t operate like that but rather simply track a third party index. It is counterintuitive that an unmanaged portfolio would beat an actively-managed portfolio that’s run by an expert, but the evidence is that these experts can’t consistent produce performance returns that are better than what they charge for their service. In the long run, index fund investing outperforms.

Why should you care about the zero sum game?

See also: Why You Should Care About The Zero Sum Game (video)

Before costs, trading stocks and mutual funds are a zero sum gain, meaning one person’s gain is equivalent to another’s loss. This video shows a bell curve of returns distributed around the market average. But when costs are included, this bell curve shifts left and many fewer can outperform the average return. (I think this graphic explanation is superb.)

Why does indexing work?

See also: Why Indexing Works (video)

Suppose you understand that every trade has somebody on the winning side and someone on the losing side, with respect to the market average, but deep inside you believe that it has got to be the experts on the winning side and amateurs on the losing side. Seems logical, rational. But there is abundant evidence that shows how this falls apart once costs are included, the experts actually underperform in the long run. Sure, every year some managers beat the market and they use that to their marketing advantage. But the winners differ from year to year and in the long run the winners are those that can actually achieve the market average, and they do this by investing at the lowest possible cost.

Questions about Target Date Retirement Funds


What are target date funds?

See also: What are Target Date Funds?

Target date investments, like balanced funds,  include both stocks and bonds and automatically rebalance  to maintain those levels. But, unlike balanced funds, you select a target date investment with your retirement date in mind and the fund gradually becomes more conservative. This is a very simple solution for many investors, but the best funds are funds of index funds, and do not add an additional management fee for managing the funds.

How does a target date fund work?

See also: How Does a Target Date Fund Work?

Investment risk and investment costs are two important topics for investors. A starting point for choosing an appropriate level of investment risk is to “own your age in bonds”. But this is not the very best answer for all situations and, in fact, every situation is different. So while a target date fund gradually becomes more conservative as you approach retirement, you should look at the specific path it follows, called a glide path, and determine whether this is what you want.

Further, some mutual fund company charge an additional fee since they implement this solution as a fund of funds. Investors need to check whether this adds another layer of fund expense on top of a weighted average of the underlying fund expenses (call expense ratio). The Vanguard target date funds provide a good benchmark to compare against since the underlying funds are low-cost index funds and no additional fee is added to manage the funds.

How do you choose target date funds?

See also: How To Choose A Target Date Fund?

The simple answer would be to pick the fund with a date closest to when you might retire, say the year you’ll turn age 65. But a more thoughtful approach would be to consider whether your needs might be different, or you might prefer a different level of investment risk. You can easily see the ratio of stocks and bonds for each of the target date funds and choose a different one. You do not need to choose one because of the year the put in the fund’s name!

The other important factor to always consider is costs. Is this the cheapest way for you to own this allocation of stocks/bonds? And if you will not be holding the fund in a tax-advantaged retirement account, you may wish to consider whether holding a fund with both stocks and bonds is sufficiently tax efficient for you.

How do Vanguard target date investments compare with competition?

See also: Vanguard Target Date Funds

Vanguard’s target date investment funds provide you a good benchmark to compare other product against. They are excellent because they are based on index funds, and the annual cost is simply the weighted average of the expense ratio with no additional fee added to manage the collection of funds. When you investments are sufficiently large that you could qualify for the lowest cost Vanguard funds, you might do slightly better on your own, but for that tiny savings you’ll have to continually rebalance the funds yourself.

 



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