Stock index funds are wildly popular – and for good reason. They allow you to participate in stock market performance with a diversified portfolio at a fraction of the cost that most mutual funds charge. It’s a pretty compelling story – but it’s not the complete story. Unfortunately, many investors fail to consider the entire picture and as a result end up with sub-par performance that could have been improved.
Background
First, remember that stock index funds can either be exchange traded funds or mutual funds. For our purposes, the difference between stock index funds and other funds is that an index fund buys stocks that make up an index and holds on to them. This is known as a passively managed fund. Actively managed funds are..well….actively managed. They have fund managers that buy and sell stocks all the time. By definition, there is very little trading done within this index portfolio.
This drives the cost way down because the index fund doesn’t have to hire the fancy (expensive) fund manager or management team. This also reduces costs because lower trading also results in fewer short-term and long-term realized taxable gains. Index fund proponents argue that these cost reductions result in better returns for investors.
They continue by saying that most mutual funds fail to perform as well as the indexes – which is true. In any given year up to 85% of the actively managed funds fail to perform as well as the index. As a result of the cost savings inherent in index fund investing and the performance lag of other competing alternatives, stock index funds are a no-brainer decision they conclude.
Is it really so simple? Is it an open and shut case? No, it is not. Few things are black and white in life. Stock index funds are no exception.
1. Performance
It is true that stock index funds have (as a general rule) lower mutual fund expenses compared to other funds. And those cost savings absolutely help boost performance. And if performance (before fees) was equal among all funds, that fund with lower costs would always be the best performer. But all funds don’t perform equally well. And it absolutely critical to understand mutual fund performance when evaluating mutual funds.
Take a look at the following performance chart for the best large cap funds over the last 10 years
As you can see, most of the top performers are mutual funds (with high expenses) – not index funds. Some even have sales charges for crying out loud. I wouldn’t suggest you buy loaded funds of course. But are you surprised to see that the best performers were NOT index funds and that the winners had higher expenses than the index fund? How is that possible if the argument the pro-indexers put forward is true?
Well….eh….actually…their argument is only partially true. You see, when you look at fund performance in Yahoo! or in the paper, that performance is quoted net of all fees. In other words, when you see performance numbers for funds, it nets out the investment fees for you. So when you compare funds by their performance, you don’t have to subtract out the fees the fund charges. That’s already built in.
And while it’s true that most funds fail to beat the index, some funds do. Depending on the market cycle, the percentage of funds that beat the index can be 15% or more. There are 10,000 funds available now. That means there are at least 1500 funds that did beat the market last year. That’s not too bad. There are funds that beat the indexes. Sometimes it will be easier to find those funds than other times, but they are always there.
It’ not simple to identify those outperformers but it’s not impossible either. There are a number of mutual fund newsletters that provide this kind of data and a few do it quite well. This is not to say that they always beat the market. But over many years some of those newsletters have outstanding track records.
2. Risk
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Now that we’ve discussed the issue of performance, let’s consider risk. Many investors falsely assume that stock index funds are all broadly based and are modest risk investments. But this is not true. All stock index funds are not alike. Consider two examples.
SPY is a very broad index fund and it generally tracks the performance of the S&P 500. This stock index fund holds 500 stocks and has very low expenses. The stocks are in different industries and sectors. This is indeed a moderate risk portfolio.
Now consider XLE. This is a stock index fund too but it replicates an energy index. It is very narrowly based. And this index fund holds only 43 stocks currently.
Both SPY and XLE are stock index funds but they are hardly in the same risk category. SPY is a broadly based fund and appropriate for a moderate portfolio. XLE on the other hand is a highly volatile investment only suitable for investors willing to take on a great deal of risk.
Stock index funds might be a great addition to your investment holdings. But don’t assume that your index fund is going to turn in good performance or that the risks are low. As you can see, there will always be a big crop of mutual funds that beat index funds. On top of that, some stock index funds have much higher risk than actively managed mutual funds.
Do you invest exclusively in stock index funds? Why or why not?
ttfitz says
I thought this post, like most of yours about index vs. managed funds, was from a number of years ago, 2009 for most I found. So I thought it would be interesting to look at that same list from Kiplinger’s, see what might have changed. As I suspected, most of the Top 10 over 10 years were not on the latest list – only 3 out of the 10 are.
But I WAS surprised to see, upon closer checking, to see that your list was from January 31, 2013! So, between the end of January and the end of June, only 3 out of the 10 top stock mutual funds are still in the Top 10. By your evaluation, not the best record for managed funds.
Also, the 3 that still remain on the list after only 5 months have dropped around 1% each in their 10 year average returns.
Simon @ Modest Money says
Thx for shedding light on index and mutual funds. While I don’t exclusively invest in stock index funds, the hype sorrounding them and their safety is quite hard to miss. And you make a good argument, sometimes its good to do your own research and identify opportunities like well managed funds with good returns that come with some fees.
Sometimes we might be blinded by the “cheapness” or “safety” of an index fund even when we are not getting worthy results from them. At the end of the day though, there still lies wisdom in spreading your risks and diversifying your portfolio through and index fund!