The Investing Secret Your Broker Won't Tell You

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Indexing can make you feel like an investing genius. Here are the major benefits of indexing:

– Market returns (which are superior returns)
– Low cost
– Broad diversification
– Tax efficiency
– Minimal cash holdings

Let’s take a look at these more closely.

Market Returns

Index funds make a simple promise: Everybody who indexes will earn market returns minus low transaction costs.

Here’s an example: If the S&P 500 index (the popular benchmark for blue chip stocks) generated a yearly return of 9 percent, you could count on the Vanguard 500 Index Fund, the Fidelity Spartan 500 Index Fund, or some other large-cap index fund to produce a return that’s almost identical.

The goal of an index fund manager is to be a clone of a corresponding index.

When an index stumbles, so will its index fund. When the index is doing well, so will the index fund. Over time, stocks and bonds of every size and category have grown, which means index funds have too.

It is perfectly understandable if you’re not impressed by “average” market returns. After all, it’s far easier to tout the stellar returns of carefully selected actively managed funds. Unfortunately, these returns are almost always ephemeral. An actively managed fund can enjoy a streak of phenomenal luck—but nearly all actively managed funds eventually stumble. Their long-term (and even shorter-term) performance returns lag behind comparable index funds.

Why do proponents of actively managed funds struggle so much against those average returns?

These stock jockeys eventually smack into a brick wall called the “efficient market.” Think about it this way: Wall Street is transparent—any news about any stock quickly makes the rounds, and the stock is adjusted accordingly. Consequently, it’s almost impossible for professionals to outsmart all the other investors trying to beat the markets.

The difficulty of surpassing index returns on a sustained basis is even harder than it appears, thanks to something called “survivor bias.” Every year, a huge number of actively managed funds go out of business. During one recent five-year period, according to Standard & Poor’s, more than one in four stock funds vanished. The funds that disappear are typically the ones with terrible performance statistics. Fund companies will often get rid of the embarrassing funds by merging them into more successful ones.
With the dead bodies hidden away, the remaining actively managed funds look better than they deserve.

Low Cost and Lovin’ It

Index funds are the cheapest game in town. The Vanguard 500 Index Fund, which is the nation’s most popular index fund, charges shareholders just 0.15 percent to manage their assets. That means if you had $10,000 invested in the fund, your tab for the year would be a paltry $15. There are even cheaper class shares for larger investors. For a new shareholder who invests at least $100,000 in the Vanguard 500 Index, the cost would drop to 0.07 percent, or only $70 a year.

The typical mutual fund can easily charge ten times more than a comparable index fund. People don’t appreciate that price gap, because the difference doesn’t seem wide. A fund that charges 1.7 percent doesn’t seem like a porker compared to one that charges 0.07 percent. In reality, the gulf is huge.

Let’s suppose you invested $50,000 in a stock index fund that charges 0.20 percent in expenses, and your neighbor invested the same amount in an actively managed stock fund that charges 2 percent. Let’s assume you both earned an annual 8 percent return before expenses.

A decade later, your index fund would be worth $105,964. The fund of the poor guy next door would be worth $89,542. Your neighbor’s cost for holding this fund would have been $16,422.

Broad Diversification

Index funds hold more securities than actively managed funds. By diversifying the number of holdings, index funds reduce the risk of having a concentrated position in a smaller number of stocks.

Tax Efficiency

When judging mutual funds, investors look at total returns. But performance statistics can be misleading. When investments aren’t sheltered in retirement accounts, after-tax returns are the key feature.

Taxes can mangle the returns of actively managed funds. Too many portfolio managers trade stocks with little regard for the tax consequences that are borne by the investor. Index funds are considered paragons of tax efficiency because there is little turnover in their portfolios.

John Bogle, the former head of the Vanguard Group, conducted a study that illustrated how devastating the tax bite can be for actively managed funds. Over a sixteen-year period, Bogle concluded that investors kept only 47 percent of the cumulative return of the average actively managed stock fund. Indexers kept 87 percent.

Can you afford to leave that much of your money on the table?

Minimal Cash Holdings

Large cash holdings reduce returns in a rising market. Index funds typically have less cash holdings than actively managed funds because they don’t have to keep cash on hand to time the market. Index fund portfolios stay focused on meeting the returns of the index.

Investors who index achieve superior returns.

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