6 things you probably didn’t know about index funds
Reprinted courtesy of MarketWatch.com
Published: Feb. 7, 2019
To read the original article click here
Index funds are well known and increasingly popular, deservedly so in my opinion.
But despite their popularity, index funds have some attributes that are not as widely known as they should be. Here are six.
1. Vanguard once was the lowest-cost source for index funds. But now that distinction belongs to Fidelity Investments.
Vanguard’s expenses are still extremely low. But Fidelity offers four index funds with “zero” expense ratios (with cute ticker symbols): Fidelity ZERO Total Market Index Fund FZROX, +0.86%, Fidelity ZERO Large Cap Index Fund (FNILX), Fidelity ZERO International Index Fund FZILX, +1.14%, and Fidelity ZERO Extended Market Index (FZIPX).
Out of its own pockets, Fidelity pays a subadviser a small fee to operate the funds. Why does Fidelity do this? Probably in the hope that big investors will open accounts in which they later decide to trade securities (and thus pay commissions to Fidelity) or put money into other mutual funds that do charge expenses.
Fidelity has no minimum required investment for these funds, compared with $3,000 for Vanguard funds.
Will a zero expense ratio make a huge difference to individual investors? Probably not. If you have $100,000 in the Vanguard 500 Index Admiral Fund VFIAX, +0.75%, you’d pay 0.04% a year in expenses, or $40 a year. About 11 cents a day.
2. Even though his company was the first to offer index funds to individual investors, Vanguard founder and chairman John Bogle (who passed away early this year at the age of 89) did not invent the index fund. Nor was he always an index-fund fan.
Read: Jack Bogle was the greatest investor who never managed money
In a recent article in The Wall Street Journal, Jason Zweig reported that Bogle, using a pen name, wrote in a trade journal in 1960 his opinion that the index fund was a flawed concept that would underperform its benchmark by about 0.75 percentage points annually. He also opined that index funds were so inflexible that they would not be desirable for average investors.
In a speech to a trade group in 1973, Bogle said he didn’t see how mutual funds’ “demonstrated excellence” could be much better than it was at that time.
Three years later, Bogle shook up the industry by founding Vanguard and launching what’s now the Vanguard 500 Index Fund VFINX, +0.75%. In the following two years, Vanguard eliminated sales commissions from all its funds and cut its annual expense ratios to below the industry average.
If you want to understand how important a change this really is, I recommend Bogle’s “The Little Book of Common Sense Investing.”
3. Totally aside from fees and expenses, index funds are not all created equal. An index of any given asset class can be constructed in various ways. Differences in definitions can have a major impact on performance.
Consider the case of an index of small-cap U.S. stocks. At what point does a company become too big to qualify for such an index? Most small-cap funds invest in companies worth less than $2 billion, but quite a few include companies nearly twice that size.
In periods when small companies outperform larger ones, the $2 billion cutoff is likely to produce a higher return than $3 billion.
Yet, in the absence of any laws to the contrary, each of those indexes could legitimately be called “small-cap.”
Even large-cap blend funds that seek to mimic the S&P 500 index SPX, -0.19% can have significant differences. The difference between the average size company in Fidelity’s and Vanguard’s large-cap blend funds is nearly $10 billion.
So far this year, smaller companies have outperformed larger ones, giving Vanguard an edge here.
4. The IRS probably would prefer that you own actively managed funds instead of index funds. The reason: Index funds take a buy-and-hold approach to investing, and their lower turnover means fewer trades, thus fewer capital gains on which shareholders must pay taxes.
This is good news to shareholders: According to Morningstar, over the past 15 years, the after-tax returns of S&P 500 index funds have been in the top 11% of all large-cap blend funds.
The relatively low turnover also helps shareholders by reducing the costs of trading, which include commissions and spreads between bid and ask prices.
5. Overall, investors in index funds make more money and are more content than shareholders in actively managed funds.
Consider the investor who is drawn to active management. He’s always looking for the best manager, always knowing somebody better might be just over the horizon. How else do you beat the market? So there can never be much rest, and there’s always somebody with a story or strategy that’s newer or seems better.
So our investor ditches his current manager, incurring (he hopes) capital-gains taxes. But he can’t rest for long, since some OTHER manager is sure to come along with a compelling sales pitch.
This restlessness also infects our investor’s behavior during bear markets. Sure, things might be tough out there, but how come my manager didn’t protect me? So he sells, almost certainly when prices are relatively low, and he likely buys back when prices are higher. (Just the opposite of buying low and selling high.)
This investor is not content, and he’s not making good money.
Now consider the index fund investor. He’s willing to accept the returns of the overall market, trusting that lower fees, more diversification and lower turnover will be to his long-term benefit. He spends less time thinking and worrying about his investments. And his relative content is likely to help him stay the course during the hard times.
Result: He’s more content and more likely to make good money over the long term.
6. In asset classes beyond the S&P 500, index funds usually look even better when compared with actively managed funds.
On average, across all equity asset classes, only about 8% of actively managed funds beat their indexes. The differences are very significant.
The best funds in the bottom 25% of the total (all these are actively managed) typically achieve no more than 80% of the returns of index funds. That means if the average index fund made 10%, then one quarter of active managers made no more than 8%.
Of course no mutual-fund investor thinks he’ll choose a loser for a manager. But it happens. A lot.
For readers hungry for more good material, I’ve recorded a podcast called “Best advice for new, midcareer and retired investors.”
Richard Buck contributed to this article.
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