Why Broad Market Index Funds Are Winning For Now

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Includes: AADR, ACIM, ACWX, AIEQ, CWI, CWS, DBAW, ESGN, EUSA, EXT, FCNTX, FLIO, HAWX, IDLB, IGRO, ITOT, IXUS, IYY, MAGA, MFDX, MFUS, NAESX, PBDM, PBUS, RFFC, SCHB, SCHF, SPDW, TBGVX, TRVLX, TTAI, TUSA, UDBI, UIVM, VEU, VEURX, VEXMX, VFINX, VGENX, VIDI, VPACX, VTI, VTMGX, VTSAX, VTSMX, VWIGX, VXUS, VYMI
by: Tom Madell

Summary

Broad market index funds, such as VTI and VXUS, have beaten out most of their comparable fund choices over the last 10 years.

But if one goes back 15 years, good funds that represented more narrow slices of the market, or non-index funds, may have done even better.

Broad index funds must use all incoming fund flows to buy the same set of stocks, creating a rigid self-reinforcing cycle.

A more flexible stock selection process will eventually allow non-broad market funds to win out.

It might seem that broad index ETFs that attempt to own the entire market, such as the Vanguard Total Stock Market ETF (NYSEARCA:VTI) for US stocks and the Vanguard Total International Stock ETF (NASDAQ:VXUS) for non-US stocks (or their comparable Vanguard mutual funds) are nearly impossible to beat. That's certainly why so many investors have made these or highly similar funds a significant part of their portfolios. But ETFs/funds that invest in somewhat more narrow slices of the market, as opposed to the broad ownership of nearly all stocks, as well as non-index (i.e. managed) funds, can still make sense too.

I have owned many stock funds down through the years, and frankly, not all of them have proven to be stellar performers, or anywhere as good as the above two ETFs. But the only mutual funds I have managed to hold on to year-in and year-out and still do (for 15 or more years to be exact) turned out to be solid performers. In fact, seven out of these ten funds wound up doing better than the above-mentioned mutual funds. The table below shows them and their long-term results as compared to VTSMX or VTMGX. (VTI and VSUS have not been available for 15 years.) Each of these funds (or comparable ETFs) remain highly recommended.

Fund Name(Symbol)

15-Year Ann. Return

Vs. Index Performance(Annualized)

Vanguard (Vang.) Small Cap Idx (MUTF:NAESX)

11.35%

+1.64%

Vang. Pacific Stock Idx (MUTF:VPACX)

8.37

+0.54

Vang. International Growth (MUTF:VWIGX)

9.84

+2.01

Vang. Extended Mkt Idx (MUTF:VEXMX)

11.20

+1.49

Vang. Energy Fund (MUTF:VGENX)

9.78

+0.07

Vang. 500 Idx (MUTF:VFINX)

9.22

-0.49

Vang. Europe Idx (MUTF:VEURX)

7.39

-0.44

Tweedy, Browne Global Value (MUTF:TBGVX)

8.77

+0.94

T Rowe Price Value Fund (MUTF:TRVLX)

9.60

-0.11

Fidelity Contra (MUTF:FCNTX)

11.96

+2.25

Notes: 1. 15-annualized performances as compared to either 9.71% for VTSMX or 7.83% for VTMGX depending on whether a US or international focus. 2. Period from June '03 through May '18.

In fact, for many years, I have operated under the assumption that acquiring in-depth knowledge including doing careful research can enable you to do better than fund investors not so engaged, and indeed, to even to come out ahead of the broad market indexes. The results above would appear to help confirm that. But especially over the last 10 years, the market-beating assumption has begun to look more and more dubious. Here's why.

Year after year, most of my individual fund selections have certainly done better than the average fund in its category. And initially, for about six or seven years between 2000 and 2007, my overall Model Stock Portfolios, as published in my Newsletter, taking into consideration individual fund selections and percent of the Portfolio allocated to each, additionally were able to come out ahead of returns on a broad market index such as the S&P 500. However, more recently, my results, while always quite close to such benchmarks, usually have tended to trail them by a small amount in the range of one-half to one percentage point.

Were my selections and possibly recommended allocations becoming poorer, or is there something fundamentally different now vs. then that likely account for this? While there is no way to know for sure, here is my guess as to an explanation.

As investors came to realize how hard it was to come out ahead of broad index funds through more costly actively-managed funds, index funds became more and more popular, and along with the ETF "revolution," investors began to pour more and more money into these passive "vanilla" index funds. Of all of the incoming money flowing into the broad index fund stocks, 100% of it had to be used to purchase the stocks that made up these indexes, seemingly forever boosting their prices.

Of course, index funds are not the only purchasers of their underlying stocks, but these days, they own a significant percentage of the total outstanding shares. And not all index fund stocks will always "automatically" go up because there may be selling activity by non-index owners. But as a general rule, index fund stocks will always get a performance boost the more money that flows into these funds.

If a fund is actively managed, it presumably is investing in perhaps some of the same index stocks, but also in less popular, non-index stocks thought to possibly help performance based on the manager's judgment. Without the constant boosting of index fund stocks, managed funds with a different make-up could only win out by a very superior stock portfolio composition, or, if there was a marked changed in which types of stocks were or not doing well, allowing the highly skilled manager to potentially recognize and capitalize on such opportunities.

Since my stock fund portfolios have always been a combination of managed and unmanaged funds, my choices too have suffered from this, as of now, still on-going disadvantage as compared to index fund stocks. Indeed, "the rich (i.e. index funds, their stocks, and their owners) were getting richer" as a self-reinforcing cycle became rooted.

If and when this situation will change is obviously unknown, but for now at least, it appears that broad index funds with their constant inflow of new money into a given set of stocks will continue to enjoy a performance advantage over most managed funds. But, at some point, there will likely come an extended period when the higher fees charged by many managed funds will be offset by their inherent flexibility in portfolio decision-making.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own the mutual fund version of the VTI ETF (VTSMX).