Overview: Passive index funds are great. They are diversified, low cost, tax efficient, easy to buy and sell, and can be liquidated quickly. They are great for beginners. They are also great for sophisticated investors who think index funds are beneath them!
So why do I think index funds are so great? When looking at a simple S&P 500 index fund like VFIAX, it has a lot of advantages over other options like individual stock buying, actively managed mutual funds, loaded funds, or hedge funds.
Diversification. Like stated in the last post, an S&P 500 index fund owns the largest 505 companies in the U.S. stock market. This provides a huge amount of diversification over owning five, ten, or twenty individual stocks. Even big blue chip stocks like Coca-Cola or GM. You can also own total stock market funds or even total world funds. When you own individual stocks, you buy some and you sell some. The problem is the person on the other side of that trade. They are most likely someone who lives and breathes these stocks, gets paid millions of dollars a year to watch them carefully, has a complete analysis of the company’s financial data, and has access to millions of dollars worth of research tools and data points. He is the person you are volleying with in stock trades. If you aren’t also a stock analyst full time, there is little chance you will be able to beat those who spend millions of dollars a month on research at the big boy level of Wall Street. You can dabble a bit in stocks if you feel like you would enjoy it, but it’s not a winning long-term strategy. If it’s not a long-term winner, why bother?
Cost. This one is Yuuge. Index funds are easy to manage and run, so their cost to own, or their ER (expense ratio) is very low. Mutual funds charge an annual expense for running the fund, expressed as a percentage. Vanguard, the king of low-cost index funds, offers VFIAX, their S&P 500 fund for only 0.04%. VTSAX, their total US stock market fund is also 0.04%. This percentage is charged yearly based on your assets in the fund. A percentage like 0.04% is dirt cheap: $4 a year for every $10,000 invested or $40 per year per $100,000! Actively managed funds, loaded funds, and hedge funds charge a lot more, in the 1-2% range or “2 and 20”. I used to think that only 1-2% didn’t sound too bad. But a calculator will prove otherwise.
An example: $100,000 portfolio with a 0.04% ER held for 20 years at 7% return ends up being $383,900. However, with a 1% ER, it ends up being $316,500 or $258,300 with a 2% ER! While a 0.04% fee costs $3600, a 1% fee costs $67,400 and a 2% fee costs over $125,000! Fees matter. Remember: In investing, you get what you don’t pay for. Watch for high fees. Loaded funds also charge a high fee, usually in the 5-6% range, and that fee comes right off the top of your investment. If you send your “advisor” a check for $1,000 to invest in a 6% loaded fund, you only invest $940. You are behind right from the beginning. Hedge funds often charge a 2% fee plus 20% of the profits.
Want a quick laugh? Here are five of some of the absolute worst mutual funds when it comes to fees (over 5%!). Be smarter than the people dumping money into these funds (probably through an “advisor”).
Many in the financial industry will claim that the higher fees produce higher returns. This sounds logical, as an actively managed fund is working hard to beat the stock market average, and lots of people are being paid very well to make that happen. There’s a problem with that logic, though. The dirty little secret is that passive (low ER funds) beat actively managed funds over the long term. The biggest reason for this is that the expensive funds first have to overcome their higher costs. If two funds go up 2% and one charges 0.04% and one charges 1.5%, the more expensive fund has a huge hurdle, just to get even with the low expense fund.
Many investors, including fund managers (that have to earn their keep with those high fund fees) end up chasing market returns, buying high and selling low, and make bets on where the market is headed. This may pay off for a few years. However, the boring old passive S&P 500 fund just keeps chugging along slowly, and over time, comes out ahead. Because my crystal ball is hazy, I don’t invest in a way that requires guessing what’s going to happen in the future.
My entire portfolio is only four index funds. I’m boring at cocktail parties where finance is being discussed. No one wants to hear my riveting tales of investment vanilla. I’m happy with market returns. Investor Bob, the life of the party, jumping from one hot stock to another, chasing hedge funds and new tech stocks, looks like a rockstar. And true, his high octane, high fee excitement in investing may beat my returns four, six, or eight years out of ten. But, over the long run, too many lessons from history show that a boring index approach wins out. Out of 11,000+ mutual funds, only four actively managed funds have beaten the S&P 500 eight consecutive years.
Taxes. Passive index funds also have a low turnover rate which saves on capital gains taxes. Actively managed funds become more tax inefficient because of the churning, or turnover in stocks within the fund. An actively managed fund manager is trying to play and beat the market, and will inevitably have to buy and sell more stocks within that fund. This selling can cause capital gains to increase, increasing your tax burden if held in a taxable account. Many of the passive index funds have a turnover of 4-5% whereas some active funds can be 250%+. That gets expensive to own.
Again, everyone wants to own the next Facebook or Microsoft. If you buy the market index, don’t sweat it, you already own it.