In my short investment journey, I have read books, articles, and blog posts about the merits of index funds. “Invest in index funds”, they say, “and stop wasting your money on management fees!” Are the authors really telling the truth?
Passive investing
The idea behind an index fund is simple enough: all it does is track the performance of its underlying index. The operation of an index fund is also simple: all it has to do is buy and sell stocks to keep in line with actual market activity.
There is no need for a team of highly skilled professionals when it comes to an index fund, since the buying and selling is driven by the overall market activity. This results in lower management expense ratios (MERs).
Active investing
Actively managed funds, on the other hand, aren’t just content with matching the index: they seek to actively beat the index. They have a highly skilled team which spends a lot of time researching, building complex computer programs and models, and focuses a lot of activity into buying and selling.
Sometimes, all of this activity and research pays off, and a fund manages to pull ahead of the market. Some even get lucky and manage to do it for a few years. Unfortunately, all of that skilled expertise and active buying and selling results in higher management fees and taxes, which hurts overall returns.
With a combined disadvantage of higher MERs and higher taxation due to higher turnover, active funds eventually succumb to the superior compound growth of index funds.
Performance
So, how do management fees impact overall returns? Just check out the following chart, which shows what happens to your investment under different fee levels.
For this chart, we assume that our market investment returns 10% year over year. On this return, we have three different funds: The Vanguard index fund, with a MER of 0.20%, an equity mutual fund, with a MER of 1.50%, and a high-fee mutual fund (such as you might find at your bank), with a MER of 2.50%.
On an initial investment of $1000, the market returns about $45,000. The Vanguard index fund loses very little with its small MER and does almost as well as the market. On the other hand, your standard equity mutual fund and your standard high-fee actively managed fund perform much worse after management expense ratios are taken into account.
If MERs were the only downside of actively managed funds, then there might still be a strong case for them. After all, they claim to be able to spot market problems before they occur, and therefore protect you from losses. If that were true, then actively managed funds could still be a good play. History, however, shows that navigating the markets can be like swimming in shark-infested waters, even for the pros, and the sharks can have a mean bite.
So why doesn’t everyone just switch over to passive funds?
Well, for one, many people aren’t content with receiving merely market returns. Many people truly believe that with the right research, skill, and a little bit of luck, they can leave the market in their dust. Some investors have had success doing so, themselves, but then again, they are not paying management fees to themselves, and many investors are not able to keep this up over the long term.
If everyone were to switch to index funds tomorrow, then there might be a problem. Index funds rely on active market movement in order to function. If everyone is just sitting around and nobody is actually actively buying and selling stocks, then how do you determine price and value?
The great thing about passive index funds is that so long as some people continue to believe that they can beat the market and invest in active funds, they will continue to work. With an index fund, you can benefit from all of the activity on the markets, without having to pay exorbitant management fees along the way.
The Canadian experience
Here is a quick rundown of some mutual funds available at Canadian banks, and their corresponding MERs.
| BMO Mutual Funds | MER |
|---|---|
| BMO Equity Index Fund | 1.00% |
| BMO U.S. Equity Index Fund | 1.10% |
| BMO Dividend Fund | 1.70% |
| BMO LifeStage Plus 2030 Fund | 2.73% |
| RBC Mutual Funds | MER |
|---|---|
| RBC Canadian Index Fund | 0.68% |
| RBC U.S. Index Fund | 0.69% |
| RBC Canadian Equity Fund | 1.97% |
| RBC Balanced Growth Fund | 2.26% |
| TD Mutual Funds | MER |
|---|---|
| TD Canadian Index | 0.31% |
| TD US Index | 0.33% |
| TD Balanced Index | 0.83% |
| TD Canadian Equity | 2.07% |
To add insult to injury, many of these high MER funds also have additional fees associated with them, such as “Deferred Sales”, “Front End”, “Back End”, and “Low Load”. With so many factors against you, along with advisors skilled at making you feel dumb, it’s no wonder why many people become bitter with the markets.
Investing It Wisely
I recommend a core portfolio of index funds, with the lowest MERs you can get and never with any additional fees. Please see the posts Living to 100 and Beyond: Building an Infinite Portfolio and Living to 100 and Beyond: Building Your Portfolio for more on these points.
So, what do you think about investing with index funds? I find that they are a little controversial even today, but the performance is there, and the low fees and expenses cannot be beat!
Awesome graph! I think there are two reasons why people don’t index. First, many people are unwilling to learn about the market so they just hand their assets over to an advisor and pay the big bucks. I think this will be less in the future because 401(k)s etc. are forcing people to learn about markets.
The second reason is that indexing, in a sense, is counter-intuitive. In just about every other area of life one gets ahead by hard work, hard study and effort. It only seems natural that when an advisor shows up with all kinds of credentials, fancy charts and company analyses, and elaborate macroeconomic studies, that they can beat the market. On a simpler level it seems like we can get an advantage at the grocery store by changing lines. But when everyone else has the same idea there is no advantage to be gained. The only gain is in the advisor’s account!
Agreed, index funds really are counter-intuitive in that sense. People don’t see how a fund that just tracks can possible outperform an actively managed fund over time. What they miss is that in a market, everything is interconnected, and by investing in index funds you can benefit from all of that activity without actually paying the extra fees.
I wonder if active funds have more of a case in less efficient markets, such as those found in developing nations.
Simple analysis with spot on results Kevin. In the near future my self directed RRSP account to be will be going into index funds, no hastle, no looking back for the next xx years…
Nice graphic Kevin! Indexing is boring, but the superior returns are undeniable. Too many people enjoy the thrill of “gambling” with their retirement portfolios without considering the long-term implications to reiterate DIY Investor’s point.
Agreed; well, everyone knows that a casino always wins in the long run, but people still try and press their luck!
In the long run, EVERYTHING returns to mean performance. The trick is to frankly get lucky and ride the outperformance for a while and then get out before the fund mean reverts.
I disagree. Don’t rely on luck. Instead minimize costs and allocate appropriately. See
http://www.cedaradvisors.com/forms/BlackRock2009.pdf which shows a 65%stock/35% fixed income portfolio over 20 years. This portfolio quadrupled in value! This in an environment where we had 2 serious market crashes, the financial system on the brink of collapse, and the worst recession since the 1930s. The key, in my view, is to have a long enough investment horizon to weather the down turns.
Interesting graph there. It shows the advantage of staying invested for the longer-term; large cap value fell very hard in 2008, but if you look at the long run, it rose high enough that even after that hard fall and subsequent small rise, it still returned the most amongst the compared categories.
Sam, I don’t think that’s good advice. Just close your eyes and hope to get lucky? How do you find the fund that is about to start outperforming the market? And how do you know when it has reached the peak? If you try to time the market like that you’ll need a lot of luck on your side.
Investing outside of an index fund is a lot of luck. The most important thing is asset allocation. It’s what’s saved me this year getting out of the markets at the end of April at +11%, and what has saved me again as we head into the close.
I don’t think my 17% outperformance on my mother fund is skill. It’s luck, and being happy with a 10%+ return in this market.
Sam
Asset allocation is definitely important. I’m personally not one for hoping to get lucky with one’s savings, and that’s what I like about the indexes because a market return will beat 90%+ of all mutual funds out there, but if someone wants to try their luck with a bit of side money, then that’s fine. Just don’t do it with money you can’t afford to lose. 😉
Kevin, this is a fabulous post! It was so complete. I’m glad that you mentioned excessive taxes, via turnover from active accounts. In a taxable account, an actively managed fund has to beat an index fund by 1% annually to match the index’s after tax return.
Financial Samurai makes a good point about mean aversion. Sam, do you buy actively managed funds, individual stocks or indexes?
DIY investor has a good point if Sam is trying to get lucky with funds, but I’ve never met a Samurai that buys actively managed funds before. Then again, I’ve never met a Samurai.
There’s no such law of “reversion to the mean”, but statistically, that is usually how things end up. There’s just no way of knowing how fast or slow that can happen, though. This is a common phenomenon seen in poker, too. Someone can actually be a newbie but hit monster hand after monster hand, and clean everyone out on the table. Conversely, someone can be an expert, but get dealt the crappiest cards time after time.
I think that self-directed investing into specific stocks makes more sense if you’re doing the research, taking the time, and not gambling with the entire nest egg. If you’re going to pay someone else to do it…. well, why not diversify yourself across all active players, buy into an index, and avoid the fees, too!
I’m a big proponent of index funds because the expenses are so low and over time they outperform most other funds. But I think many people don’t like them because they aren’t sexy enough. They want to be in the fund that is outperforming the index instead of just “settling”. but more times than not they end up lagging behind the index, especially after fees are taken into account.
It also doesn’t help that many people just listen to whatever their advisor tells them instead of doing more research or getting a second opinion, as DIY Investor suggested!
This might be a case where the hare loses to the tortoise, not because the hare takes a nap, but because the hare spends too much time zigging and zagging left and right while the tortoise just plows straight on through.
I used to be a much more ‘active’ investor, but as I have gotten older, I have relied more on index funds. I do love the low expenses, and I like the diversification.
Now I need to think more about where else to put our money besides stocks. I have not invested in any commodities, and I am wondering if that is something I should consider.
Commodities are definitely a riskier investment, but I don’t think demand for oil or other resources is going away anytime soon. If you’re ever interested in reading more, you can check out my friend’s blog at http://www.beatingtheindex.com and his adventures in commodity investing!
Kevin,
Thanks for the compelling and logical discussion of the advantages of index funds. I think most of us try to make investing more complicated than it is. This post explains index fund investing so well that even I can understand it.
Yep, I think for the core portfolio, it really comes down to picking a few index funds, adding to them through dollar cost averaging, and rebalancing between them every now and them to keep allocations in line. This allows you to buy low and sell high without having to time the market.
Kevin,
Right on the money! Very complete article. To play the devils advocate, as a portfolio manager, I used to buy undervalued conservative equities in an attempt to beat the market. Overall, I did well….. (most years, not all, I beat my benchmarks) but here’s the rub, it was my job & it is incredibly time consuming. It was also fun and challenging, almost like a treasure hunt. In my professional portfolio, I have gone to an indexing approach, and that’s why I have so much time to blog! Clearly, the research is in favor of INDEXING.
Hey Barb,
Nothing wrong with doing the research and the picks if that’s what you love to do! I’m sure that paying yourself MERs wasn’t so bad 😉
On the other hand, that’s an interesting point that you raise about the time required for research. Another reason I go with indexed funds is that I don’t have the time or inclination to research every individual stock out there, so, I take advantage of the specialization of labour, let those who do this for a living drive this activity for me, and benefit off of their collective wisdom through the index funds. 🙂
Nice post Kevin! I would agree with DIY Investor – most people don’t have (or want to take) the time or effort to learn about the markets, even at a primary-level. This is concerning and I’ll say why…
Having somebody “do it for them” is an easy thing to do; and you can’t blame people for this. I don’t. I use specialists all the time. We all do. For example, we use mechanics for our cars; plumbers for our severely clogged drains; carpenters to build our patio decks. However, what I don’t understand, some people who ask questions of their mechanics, plumbers and carpenters, for whatever reason, don’t ask the same questions of their financial advisor/manager and in turn, blame them for lack of performance or results. If you don’t care what the mechanic does with your car, don’t complain about the results. If you’re not concerned about your drain, don’t ask the plumber any questions and let them do their thing. If it doesn’t matter what your patio deck looks like, then just hire the carpenter, close your eyes and hand over the money. A financial advisor/manager should be no different. If you’re not taking some time to get vested in the process you have little reason to complain about the outcomes 😉
Good points. It used to be like this with doctors. The doctor would say you need an operation and people would accept it as expert opinion. Now most people realize they should get a second opinion. The investment world is even more complex. Get an advisor and he puts you into funds that do horribly and he blames the funds and then turns around and recommends other funds. And people pay for this!
If he buys Fannie Mae or Freddie Mac stock he blames government policy and thereby deflects criticism of his inept analysis.
Students in high school should be presented with the evidence on the long term performance of active managers. They should be shown the costs of investing in mutual funds.
Maybe the solution is to require everybody to read “The Elements of Investing” by Malkiel and Ellis and then take a driver’s license type test.
It is a huge problem as is going to be revealed when the bulk of the baby boomers start retiring.
You guys both bring up pretty good points. I think part of the problem is also that people want to know that someone out there is looking for their interests; financial advisors are very skilled at presenting things a certain way, as they have the upper hand in knowledge and a vested interest in doing so. A 2% MER also doesn’t sound so bad when you don’t know what it costs you over the long run.
@DIY – I haven’t read that book. It is good?
All of my ranting to say, I’m a fan of index funds gang – espcially in my registered accounts. Unregistered, love the dividend-payers…
It’s pretty good and importantly it can be read easily in a weekend. Malkiel and Ellis bring a world of experience to the world of investing. Guess what? Even they don’t put all their money in index funds. They realize that trying to pick good companies is a great challenge and a lot of fun!
I like the graph, but it looks as though if one gets a late start in investing, the index fund would grow quite slowly. For instance, I’m a little behind on retirement planning. If I sunk my money in an index fund, I don’t have 45 years before retirement, I have more like 25-30. I don’t think the index fund would be at full potential at that point. Maybe I need to just make sure I’m highly diversified.
Compound growth is really amazing, isn’t it? Your $1000 is still around $11000 after 25 years.
I recommend that any investment in the stock markets be held for the long term due to volatility, but if you don’t plan on withdrawing and spending the whole sum when you retire, then you can still take advantage of that great 40 year+ growth. If you withdraw only 3% from your portfolio every year, you get a pre-inflation pay raise of 7% per year. Of course, things will change from year to year over the short-term, but that’s what the long-term looks like. Not too shabby, eh?
You should read Andrew Hallam’s “Beating the market with bonds”. It offers a way to still get very good returns, while cutting down on some of that volatility.
You could also look into dividend investing, which perhaps trades a bit of volatility and potential long term capital growth into current income. My fellow commentators have more expertise in that than I do, but I believe it’s an interesting approach to building up passive income.
This article is a sham. You cannot assume all of these funds will perform the same! The whole point of actively managed funds is to outperform the index. And if you look at history… there are a TON of actively managed funds that out perform the index so the sales charge is easily returned. Faulty assumptions…
To have a CORRECT graph.. show the history of those mutual funds for the past 30 years to truly see how they performed.. and you will see the actively managed funds will have out performed them.. especially if you pick quality funds…
While it’s possible to pick star winners in hindsight, in most situations you will be better off by avoiding the fees, loads, tax implications, and inferior performance that you get from going with someone who’s point is to “outperform” the index, which also means that they are trying to outperform each other. By definition there will be losers, and many of them once you add up all of the charges and fees.
You are right …there are a ton of funds that outperform. Over the next 20 years, after fees, approximately 20% of the funds, based on historical data, will outperform. Given that there are 100s of 1000s of funds out there there will be a ton that outperform. If you can pick the 2 red balls out of 10 balls where 8 are white go for it. Nobody yet has shown how to to do it.
What is a “quality fund”? One that has outperformed in the past? Sort of like Bill Miller who was the cream of the crop until he came in dead last? Or Long Term Capital Management whose under-performance had to have the Federal Reserve brought in to engineer a rescue?
I agree completely, Robert. I think what makes the most sense is if you have a passion for a sector, the proper mindset, and the willingness to do the research, then you can probably do pretty well on your own. I don’t think paying a large fund manager with plenty of money and interests besides yours to try and beat the index for you will work out as well.
I’m 14 and looking to invest and by stocks. Should I get a mutual fund?