The Fall of Index Funds

Financial experts have long championed the cause of index funds. They are viewed as the low cost simple way to invest. An index fund is a mutual fund that tracks the movements of a particular index. There are index funds that track the S&P 500, Wilshire 5000, total stock market and so on. Index funds are passive investments. Index funds are a way to invest without being concerned about the performance of any one particular stock or sector. Index funds worked well in the past but lately the results have been rocky.

I will take a look at four of the Vanguard Group’s mutual funds for the sake of comparison. Two of the funds are index funds and the other two are balanced funds. They are neither the best or worst performing funds that Vanguard has to offer. They are well known funds that most investors are familiar with.

Let’s say you had invested in the Vanguard 500 Index Fund 10 years ago. You have lost 1% annually for the past 10 years. How about if you had invested in the Vanguard Total Stock Market Index Fund? You are down an average of 0.3% annually over the last 10 years. The expense ratio for these two index funds was 0.15%. You could have beat these returns by taking your money and sitting it in a drawer.

What if you had invested in the Vanguard Wellington Fund over the same time period? You would have an average annual return of over 4% for the last 10 years. The Vanguard Wellesley Income Fund would have returned over 4.5% annually. The expense ratios were 0.27% and 0.25% respectively. The average annual returns were still positive even after accounting for taxes and the great market decline of 2008.

In 1998, if you had invested in an index fund that tracked the S&P 500 index you have actually lost money. It is my expectation that this trend of poor performance by index funds will continue. Index funds thrive during great bull markets. This type of environment is unlikely going forward. The historical average return of the stock market has been roughly 10% per annum. The double digit growth that we are used to may be a thing of the past. As the economy slows, the market is expected to grow in the single digits for the foreseeable future. This places greater emphasis on the selection of assets and not just following the market as a whole. Investors will struggle to achieve anywhere close to the same returns as they did in the 90s by investing in index funds.

So, actively managed funds should produce the high returns of the 90’s? No, but actively managed funds should hold up better in a slower growth environment that requires flexibility. Actively managed funds have greater flexibility to manage risk by reducing positions and holding cash. Actively managed funds have greater latitude in purchasing assets in different categories. They also typically lose less than index funds during bear markets and thrive during moderate growth periods. I expect a solid conservatively managed balanced fund with a low expense ratio to outperform an index fund over the next few years.

Disclosure: no positions

Comments

[Brad Nagel:]

To make a bold statement against indexing, you should have statistics proving that active management is working. What percentage of the active managers in the large cap universe outperformed the indexes AFTER FEES since 1998?

2008 Dec 02 08:32 AM

[searcher:]

"The historical average return of the stock market has been roughly 10% per annum. The double digit growth that we are used to may be a thing of the past. As the economy slows, the market is expected to grow in the single digits for the foreseeable future."

So, we are right back to step one due to the crux of any market position other than neutral "..for the foreseeable future." Emphasis 'foreseeable'.

2008 Dec 02 11:59 AM

[Xyrus:]

Wow. Just wow.

You're looking at a very limited subset of time and proclaiming indexing is dead based on your "foreseeable" future. That's incredibly naive.

As an exercise, list all mutual funds that have beat the S&P since 1980, barring expenses. You may note that the number of funds that have done so is exceedingly small.

People who index don't look at 5 or 10 year records. They look at 20, 30, or 40 year records. They look at dollar cost averaging, which you completely omit.

Why don't you get some real long term market statistics and compare actively managed mutual funds to index funds. You may just learn something.

~X~

2008 Dec 02 01:52 PM

[Kyle Waller:]

Mark,
You say a lot of things. I think there is a lot investors don't understand about indexing. I also think some of the things you said were right yet still uninformed. Index Funds do not make any investment decisions and to say that index fund performance will continue to be poor is saying that all sectors, asset classes, and countries in the world will have, on aggregate, poor performance. This may be your opinion.

You say you expect a, "conservatively managed balanced fund with a low expense ratio" to beat an index fund over the next few years. Sir, There are hundreds of index funds, will your fund beat all of them? Maybe you only mean an index in the same peer group. If that is the case, a better comparison would be to compare a mix of index funds, weighted to match your conservative mutual fund's asset allocation.

I know this is a lot but I'd like to make the point that indexing is more complicated than just comparing a conservative mutual fund with 40% bonds, to the S&P 500.

2008 Dec 02 02:39 PM

[Mark Riddix:]

I did not state that one fund will beat all index funds. I used Vanguard because it is one of the larger fund companies. I looked at Fidelity, T Rowe Price, Legg Mason and others. There are a vast array of index funds that track different benchmarks.
And of course all sectors will not perform poorly. Some of the sector index funds, energy funds and REIT index funds have performed just fine. I am only referring to index funds that track the overall stock market's performance such as the S&P 500, Dow Jones, Wilshire 5000.

Too many investors rely solely on a stock market index fund as the one stop solution to investing. I believe investors will be better served by taking a more active approach to investing. I do not think it is unreasonable for investors to expect a positive rate of return over any 10 year period.


On Dec 02 02:39 PM Kyle Waller wrote:

> Mark,
> You say a lot of things. I think there is a lot investors don't understand
> about indexing. I also think some of the things you said were right
> yet still uninformed. Index Funds do not make any investment decisions
> and to say that index fund performance will continue to be poor is
> saying that all sectors, asset classes, and countries in the world
> will have, on aggregate, poor performance. This may be your opinion.
>
>
> You say you expect a, "conservatively managed balanced fund with
> a low expense ratio" to beat an index fund over the next few years.
> Sir, There are hundreds of index funds, will your fund beat all of
> them? Maybe you only mean an index in the same peer group. If that
> is the case, a better comparison would be to compare a mix of index
> funds, weighted to match your conservative mutual fund's asset allocation.
>
>
> I know this is a lot but I'd like to make the point that indexing
> is more complicated than just comparing a conservative mutual fund
> with 40% bonds, to the S&P 500.

2008 Dec 02 05:05 PM

[Grill Sgt:]

the author compares 2 100% stock funds against a 60%/40% bond/stock
fund and a 40%/60% bond/stock fund? What an idiot. It's apples and
oranges, not index vs. managed!

2008 Dec 03 12:20 PM

[Grill Sgt:]

Mark, I am sorry for name calling in the above comment. I was a bit
over caffeinated. I appreciate all points of view.

Best regards,

Grill Sgt

2008 Dec 03 03:08 PM

[francoamerican:]

Go back and pick a fund that has done well and declare active management victorious.

Let's talk about the Wellington fund. It's a large value fund with 30-40% fixed income. Benchmark it against a LV index fund with 30-40% fixed income then try to identify the benefits of the Guru's. At least the Wellington fund has a low expense ratio which is probably one of the main reasons it has done well (70 bps less than the average equivalent fund)

And what if YOU as an individual pick the "wrong" actively managed fund? (Since you are basically relying on yourself to have greater expertise than the "dumb" managers out there to be able to pick them out and avoid them)

Here's an article with a little more meat to it that may lead you to a different conclusion:

www.fundstrategy.co.uk...

The nice thing about articles like yours is that they make me feel smart.

2008 Dec 09 12:50 PM

[Fund Insider:]

We sell no index funds, and I personally invest all but my 401k in index and index-like funds (some of their funds they advertise in that way, such as tax managed funds, that don't exactly follow the index, but very closely). Asset allocation is what gets you those Wellington and Wellesley Income Fund returns. I know many unfortunate people who don't listen to advise and do put all their $ into equity funds, managed or index, and are very sorry they did so. In the vast majority of the cases the managed funds did worse, but still the index investors are unhappy too. You wouldn't believe how many people (maybe the author) think "index" automatically means equity. There are FIXED INCOME and balanced index funds out there, and they do perform better than actively managed fixed income/balanced funds. The few funds that were up this year (very short horizon) were long-short actively managed funds, and short index funds (think Rydex or Profunds). It is 1) long/short market timing, 2) asset allocation and 3) expenses that determine returns. This has been studied to death in many ways. Problem is, these issues don't make for as much press and details to discuss in blogs.

Also note that if you want to focus on long term investing, how often does an actively managed fund have the same management for very long periods of time ? Do you want to have the same job for 20/30 years ? Assuming they do, problem is you don't know which ones to pick until after they already have that track record, and by then they are nearing retirement ! So you are banking on the fact they will train a worth successor, no guarantee of that.

PS a financial planner friend at a major broker told me, "we have to get people back into those managed equity funds, that's the only way I can make a living" (as opposed to mmkt, CDs, individual stocks, bonds or index funds). They are not giving advice for their clients, but rather for their own pocket, and so is anyone writing articles (online, print, tv etc) about buying managed funds (and to lesser extend stock picking).
Well at least that keeps me employed, so I hope lots of SeekingAlpha readers concur with this article, so we can continue to harvest 1-2% of their money each year.

2008 Dec 10 09:35 PM

[Fund Insider:]

OMG, just read the author's bio :
He runs an "independent investment advisory firm that provides personalized consulting services". He only makes significant recurring revenue when you buy those actively managed funds, not when you buy index funds, or CDs or many other alternatives.

Disclosure on this article is insufficient, unless you assume all will read his bio and make the connection. Should say "i sell actively managed funds for a living".

2008 Dec 11 01:04 PM

[jkane:]

Seekingalpha should be embarassed, publishing such a ridiculous article, and the author should be ashamed of himself.

How is it possible for active management to "typically" lose less in bear markets after fees, when they make up the market? And the evidence is clear that active management "in general" does not lose less in bear markets. (this would be mathematically impossible, according to William Sharpe).

And why would you expect balanced funds to beat stock index funds going forward when the source of bond returns over the past 10 years was due to the higher yield environment in the past, something that is not true today? Your same prognostication that the future for stocks will be different than the past will be the same for bonds and balanced funds, since the bond environment is very different today as well.

And do you know anything about indexing? As others have pointed out, you are comparing apples and oranges, the biggest rookie mistake investors make.

Truly an embarrassment. Seekingalpha usually has some pretty bad articles, but this one takes the cake.

2008 Dec 11 02:09 PM

[danwalk:]

What an incredibly shallow and ignorant article. I find it hard to believe that an author who manages other people's money would compare a balanced fund with an equity index. I am truly shocked that SeekingAlpha published this.

2008 Dec 11 03:58 PM

[valtys:]

"I expect a solid conservatively managed balanced fund with a low expense ratio to outperform an index fund over the next few years."

This is really a gem. So the author expects some random balanced fund to beat some random index fund over the next few years. Woohoo, amazing call. I could spray diahrrea on my monitor and be looking at better content than what I am reading right now.

2008 Dec 11 08:08 PM

[TomF75:]

"So, actively managed funds should produce the high returns of the 90’s? No, but actively managed funds should hold up better in a slower growth environment that requires flexibility...They also typically lose less than index funds during bear markets and thrive during moderate growth periods."....


Would these be the same actively managed funds that are down 40% just like the indexes they mimic? Plus charge a 1.44% (or higher) Plus charge a sales load.

Thanks, but I'll stick to picking my own stocks, and using SPY or similar ETF's when I don't feel comfrotable picking them on my own (e.g. small-caps, Emerging Markets, Commodities)

2008 Dec 12 01:05 PM

[MyMoneyMD:]

I am inclined to agree with the thesis of the article, though obviously some have taken task with the comparisons used to support it. To a certain degree, this will be the old "looking for a needle in a haystack." Which managed funds will do well won't be clear ahead of time.

Feb 27 02:40 PM