Index Funds: If You Can't Beat The Market, Buy It

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Professor Burton G. Malkiel, the famous proponent of the Random Walk theory, wrote an article in the May 29, 2013 Wall Street Journal titled, "You're Paying Too Much For Investment Help."  In the article he analyzed the costs and expenses charged by actively managed mutual funds and concluded that investors looking for a better return should focus on index funds instead.  He advised investors that while they can not control the market, they can control their cost to invest in it.

An index fund is essentially a portfolio of stocks which make up an index such as the S&P 500 or the thirty stocks in the Dow Jones Average or some other index of market assets, such as the Wilshire 5,000 Total Stock Market Index.  Index funds were first offered only to institutional investors in the early 1970s.  John Bogle's company, Vanguard, was the first to offer this form of fund to individual investors, the Vanguard S&P 500 Index Fund.  Once the index of stocks has been duplicated, trading is minimal since the fund advisers only need to rebalance the fund depending on what happens to the stocks comprising the index.  This provides the individual investor with the opportunity to buy a particular market with a low expense ratio.

Given this background, an individual could rightfully ask whether it matters which particular index fund he or she purchases if they track the same index.  Won't two S&P 500 Index funds produce the same results?  Sadly, the answer is "not necessarily."

Although the costs and expenses of an index fund are lower than actively managed funds, they still exist.  The operation of an index fund involves the same functions as an active fund (see my earlier post).  A larger fund can spread those costs over more investors.  Another drag on returns is the efficiency with which a fund can buy and sell stocks, the execution/trading costs it incurs.  Some smaller funds do not actually buy all of the stocks in an index.  It is just too expensive.  They try to duplicate the index by the process of sampling.  Sampling means that the fund creates a portfolio of stocks with the same characteristics as the total index.  Keep in mind that a sample will not provide the exact same return as the total index.  Hopefully, the costs and expenses saved by sampling are passed along to the fund's shareholders to make up for the lower return they will receive.

To see how close the return of an index fund tracks the return of the actual index, the investor must look at the R-squared rating of the fund.  R-squared is a mathematical measure of the difference in returns.  If the fund's return is identical to that of the index, the R-squared is 100%.  Virtually all funds fall short due to their costs of operation and execution.  Aswath Damodaran, in his book, Investment Philosophies, suggests that investors check Morningstar rankings of index funds to find out what their R-squared percentage is.   He advised investors, "As an investor looking at index funds on a specific index, you want to pick the fund with the lowest expenses and the highest R squared."

Investment Management is a collection of chapters written by investment professionals and edited by Peter L. Bernstein and Aswath Damodaran.  The advantages of index funds are described in the book as follows:

First, no information costs or analyst expenses are associated with running these funds, and transaction costs associated with trading are low.  Most index funds have turnover ratios of less than 5 percent, indicating that the total dollar volume of trading was less than 5 percent of the market values of the funds.  Transaction costs for these funds are 0.20 percent to 0.50 percent, or less than one-third the costs of most actively managed funds.  Second, the index funds' reticence to trade reduces the tax liabilities that they create for investors.  In an typical actively managed fund, the high turnover ratios create capital gains and tax liabilities even for those investors who buy and hold these funds.*

*Excerpt from Investment Management, edited by Peter L. Bernstein and Aswath Damodaran, copyright 1998, published by John Wiley & Sons, Inc., page 228.

Comments are always welcome.