Why an index fund is so hard to beat

Index fund investing ETF exchange traded funds
Exchange traded funds tend to outperform most active funds once fees are taken into account.

There has always been a deep distrust of index investing – particularly among those who make their living picking stocks and running active funds.

They are quick to cast index investing as “passive” and “dumb’’, with a load of lemmings piling into already overpriced stocks just because their share prices are going up.

The problem with this criticism is that time and again, index investing – usually through very low fee exchange traded funds or ETFs – has been found to outperform most active alternatives when fees are taken into account.

Indeed, given that the list of active managers who outperform the index every year is short and changes annually, it is not enough to pick the right active manager to beat the index – you need to actively pick the right active manager each year.

Investment styles change but the index doesn’t

Still, the active fund spruikers are quick to say that the current success of index investing is just an indication of the sort of share market we are going through – once stocks fall enough value investors will outperform the index.

Or momentum investors will outperform once markets start to rise or active traders or quant funds will outperform when they start to move sideways or any one of the scores of different active investment strategies that blossom like mushrooms after a downpour.

The key lesson that critics never learn about the why index funds are so successful is that they are not just about low fees.

Low fees are important, of course, and they make up much of the difference between active and passive approaches but they don’t account for everything.

The numbers tell the story

In a study completed some years ago by Boston research firm Dalbar, the researchers found that the constant decisions and churning that an active approach entails was very costly.

Using US figures over 20 years the study found that the actual annualised return for the average stock mutual fund investor was only 5.19%, 4.66% lower than the 9.85% return for the Standard & Poor’s 500-stock index.

That may not sound like much but when you multiply those averages out over longer time-frames, they are devastatingly different.

Due to the compounding effect on investment returns – in which a better return is added to the total and then grows again in future years – the differences are massive.

The Dalbar numbers showed that an investment of $10,000 in the S&P 500 index including dividends would grow to $65,464 over 20 years, compared with only $27,510 over the same period for the average active fund.

At those rates after 40 years, with compounding, the nest egg invested in the plain vanilla stock index would grow to about $428,550, compared with only $75,680 for the average returns of stock mutual fund investors, a $352,870 difference.

It is wrong to think of an index ETF as passive

The other aspect of investing in an index apart from the greatly reduced amount of buying and selling and the much lower fees is that the index itself is a dynamic and very active beast.

While you may not be buying and selling out of the share market with a classic passive ETF approach, you are actively selling out of previously successful companies as they drop out of the index and buying more and more of those that enter the index and grow much larger.

In effect you can think of it as gradually buying more of the winners – a common trading strategy called pyramiding – and selling more of the losers.

That approach is actually a very long way from the “passive’’ label that is used and is quite powerful – as shown by the extreme difficulty the vast bulk of active managers have in outperforming share market and even bond indexes.

They are actually pitting their expertise and active trading methods against another active trading method that has stood the test of time and rewards patient investors with a long-term view.

Staying in the market in tough times has its rewards

The index investor also stays in for the ride without the costs incurred by trading and taxes or the lost opportunity of being “out’’ of the market when it rises sharply and unexpectedly.

Both of these characteristics have been demonstrated recently by the S&P 500, which against the bleak outlook of the COVID-19 pandemic and no shortage of bearish pronouncements and predictions from brokers and economists has managed to claw back an amazing return of 36% since bottoming on 23 March.

In doing so it has regained the vast bulk of the losses caused by the pandemic.

Any active manager that missed out on full exposure to that rise will really struggle to ever catch up, no matter what the index does from here on.

Index investing is not a buy and hold strategy

It is worth considering the contrast between this “active’’ index ETF investing with the traditional “buy and hold’’ approach of purchasing a chunk of large companies and leaving them in the bottom drawer.

A true buy and hold investor on the S&P 500 would still be hanging on to many stocks that lost favour during the COVID-19 pandemic – indeed, in the long term they would have held on to some stocks that had shrunk alarmingly and eventually been ejected out of the S&P 500 index or moved from a prominent position to being well down the list.

By contrast, the S&P 500 ETF will have long ago sold down or even sold out of some of these “duds’’ and moved on to today’s rapidly recovering stars – in this case the giant global technology stocks such as Alphabet (Google), Facebook, Amazon, Apple and Netflix.

When this current crop of “stars’’ begin to wane – which seems inconceivable at the moment but is likely in the longer term – the index will already be moving on to the next crop of stars and reducing its stake in the technology stocks and the index automatically rebalances.

Don’t be confused by active and passive labels

So, don’t be confused by the “passive’’ and “active’’ labels.

An index ETF with low fees is very much an active, long term investment that is very difficult to beat using the traditional approach of an active fund manager.

The “passive’’ label only refers to the lack of actual effort and thought being placed by the investor.

It seems counter-intuitive that a simple index approach that effectively involves doing nothing from the investor’s point of view could outperform the “smartest in the room’’ trading by the best fund managers but time and again that is exactly what the numbers show.

A combination approach is common

Of course, there is no law against combining index investing with using active managers and many investors do just that.

If you do that, it is an interesting exercise to compare the active part of your portfolio with the passive index part.

If your active section has outperformed the index, you really have shown a lot of skill in picking some of the few active funds that have overcome the index which automatically jumps on rising stocks and reduces holdings in falling ones.

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