Kinabalu

Are Index Funds the Only Rational Choice?

Mr Considine has constructed a straw man and than proceeded to demolish it with a lot of good, and irrelevant, research. The straw man is, of course, in his lead sentence: "There are many experts who believe that investors ought to invest in funds that track a broad index, and should not invest in smaller numbers of individual stocks.

The reason to invest in index funds is not to get a large number of stocks. The reason is to avoid the management and transaction fees that characterize an actively managed portfolio. Many studies, not linked by Mr. Considine, have shown that active managers can, in fact, select stocks that perform better than indexes. However, once you take out the management fees and the higher turnover costs that active management generates, the active management underperforms. Those fees and costs, often averaging 150 to 200 basis points, are too big a bogey for active management to overcome in a environment where they constitute 15% to 20% of the long term stock market return of approximately 11% per year..

A sample of "intelligently selected" portfolios of 15 stocks would probably beat an index, especially one based on a small number of stocks, until you factored in the management costs noted above. The diversification obtained by investing in an index with a large number of stocks is an ancillary benefit.