In Part 5 of the Fight Fire With FIRE Investing Guide, we briefly touched on one of the major benefits that index funds have over other types of investments: lower costs. This, however, is not the only one—not by a long shot. There are many others, and taken together, they make index investing a truly compelling strategy. Let’s take a look at some of these main advantages in more detail.
Investor JL Collins (and author of the bestselling book The Simple Path to Wealth) has noted, “Here’s an important truth. Complex investments exist only to profit those who create and sell them. Further, not only are they more costly to the investor, they are less effective” (1). This is an important truth: investing is one of those rare areas of life in which the level of success doesn’t always correlate with the level of work, time, and expense put in. In fact, as we will see, it’s the opposite: keeping those three things at a minimum means a much higher chance of a better return.
“Complex investments exist only to profit those who create and sell them.”JL Collins, The Simple Path to Wealth
Why? Well, the more complexity that is added to investing, the more layers between you and your money, the more hands touching it, the higher the costs, and the less return that is ultimately left for you. We will get into the impact of costs in a moment, but consider these fairly common examples of what I mean by added complexity:
- Hiring an investment manager to handle your investments who charges a fee of 1% AUM (assets under management).
- Investing in an actively managed fund with a front-end sales load (brokerage commission) of 5%. This fee is taken right off the top, meaning that if you invest $100, only $95 of that goes toward your contribution; the other $5 is just gone, as a fee paid to the broker.
- Choosing an actively managed fund which carries higher costs; for example, an expense ratio of 0.75% and turnover rate of 55%. We will discuss what these are next, as well as how they impact your return.
You can see how these types of costs—which are largely negated through owning a simple, indexed portfolio—can add up very quickly. All of these are examples of layers between you and your money, and each one brings with it a cost that ultimately erodes the return that is left for you. Due to the innate diversification potential of index funds, the index investor can (and typically does) have a portfolio that is vastly more simplified than that of an active investor. It is entirely possible to hold a portfolio of only 2-3 funds that is widely diversified and yet gives up nothing in potential return. And not only does simplicity mean that you will pay less in avoidable costs, it also means that the entire process will be a lot easier and more enjoyable. Simplicity means far less work, less portfolio tracking, no speculation, less emotional turmoil, and the pride of having a portfolio that you have designed and manage yourself.
This one cannot be overstated—costs really do matter. As investors, we are well-acquainted with the concept of compounding—particularly, the “magic” of compounding returns, year over year, decade over decade. John Bogle has noted that every single dollar invested in 1900 would have been worth $1,339 by the end of 2015—and this after inflation is accounted for. That kind of growth potential is staggering. But fewer of us give thought to the other side of that coin—to the peril of compounding costs. The costs of investing are everywhere—commissions, advisor fees, sales loads, transaction fees, 12b-1 fees, and so on—and yet they are, at best, a peripheral consideration for many investors. They are simply brushed off as a necessary part of investing. This is a critical mistake. For just as returns compounded over time have the potential to turn a modest amount into a true fortune, costs compounded over time can erode a potential fortune down to a modest amount.
…just as returns compounded over time have the potential to turn a modest amount into a true fortune, costs compounded over time can erode a potential fortune down to a modest amount.
Costs are typically expressed for funds in a term called an expense ratio, which is the annual fee that funds charge their shareholders. John Bogle did a study for the CFA Institute in 2014, and found that expenses for actively managed funds (including hidden fees) averaged 2.27%; for index funds, it was only 0.06% (The Bogleheads’ Guide to the Three-Fund Portfolio 36). Your fund’s expense ratio directly impacts your rate of return, and over time, this kind of difference can be huge.
Looking at an example will help drive this point home, and illustrate just how significant this difference in cost drag can be. Let’s look at two investors: one who invests in the average actively managed fund, and one who invests in the index equivalent. Both invest $500/month for 25 years, and earn an average rate of return of 8% (before costs). Net of costs, this means the following average rates of return:
- Investor 1 (Active Investor): 5.73% (8% return less 2.27% in costs)
- Investor 2 (Index Investor): 7.94% (8% return less 0.06% in costs)
How did our investors fare at the end of those 25 years? Well, our investor who chose the actively managed fund would have ended up with $316,938. Not bad. But our investor who chose the index fund would have ended up with $434,810. That’s a difference of $117,872, or an increase of 37% over the active fund—on controlling costs alone! And, as if that weren’t bad enough, here’s another sobering fact: our active investor would have lost a staggering 42% of potential profits to costs over those 25 years, whereas our index investor would have lost a mere 1%. Always remember: costs matter. Tremendously.
When a fund “changes out” the stocks that comprise it, the frequency of this is reflected in a measure called turnover. Funds with high turnover indicate that the stocks within that fund are changed out frequently; for actively managed funds, where the fund manager is constantly chasing performance, this measure can be quite high. Because index fund composition is largely static, these types of funds do not change out the stocks within them very often. This is important, because as I said before, every time a stock is bought or sold within a fund, this incurs costs within the fund. These expenses can be huge for some funds, and reduce an investor’s overall rate of return. This also has a direct impact on the tax efficiency of a given fund; funds who maintain lower turnover are far more tax efficient than those who trade the underlying securities frequently.
Let’s look at a quick comparison. In The Bogleheads’ Guide to the Three-Fund Portfolio, author Taylor Larimore points out that the turnover rates for total stock market index funds average 4%; for that same category in actively managed funds, it’s 59% (34). Thought of another way, at these rates of change, the actively managed fund would change out its entire portfolio of stocks in a mere 20 months; the index fund would take 25 years. And just how much does turnover increase the costs of a fund? John Bogle notes in The Little Book of Common Sense Investing, “assume that a fund’s turnover costs equal 1 percent of the turnover rate,” meaning that for the average actively managed fund (59%), turnover adds 0.59% to the fund’s expenses. And, as turnover is not included in a fund’s expense ratio, this is in addition to it.
Higher Than Average Rate of Return
On the surface, this sounds paradoxical. If index funds aim only to match the return of the market, how is it possible that they have a higher than average rate of return? Wouldn’t the return they offer be, by definition, average? The answer is no. When we compare index funds to actively managed funds, and the vast majority of active funds actually lag the market return over time, the return of the market then becomes above average. I can just see you now, looking something like this…
…but rest assured, it’s true. There are numerous studies that show that index funds, especially over longer timeframes, outperform nearly all actively managed funds (net of costs). What are the odds that actively managed funds will actually “beat” the market? The S&P Dow Jones Indices issues a semiannual report called the SPIVA Scorecard that offers some of the best data comparing actively managed funds to their respective benchmarks. In a recent report, evaluating a 15-year period ending mid-year 2019, it notes that 89.83% of large-cap, 90.33% of mid-cap, and 90.25% of small-cap actively managed funds failed to match the performance of their respective benchmarks (4). Said another way, with a time horizon of 15+ years, investors who choose actively managed funds have a 9 in 10 chance that their investments will underperform the benchmark index. For almost all investors, trying to beat the market all but ensures you will lose to it.
No “Human Factor” Risk
When you choose an active approach to investing, you take on several “human factor” risks that you don’t have with index investing. For example, when you pick an investment manager or fund manager (inside an actively managed fund), you are staking a lot on whether their skill amounts to something…or nothing. Their ability to predict and profit from the movements of the market, consistently, becomes the hinge on which your success or failure is determined. And when that much is riding on skill, it warrants a closer look.
So let’s focus on the supposed skill of active fund managers for a moment. The belief is that active fund managers must know what they’re doing. After all, they devote significant time, education, and expense to their attempts to outperform the market. These are the professionals, the ones that live and breathe the market. They must at least have a consistent payoff in beating the market, right? Well…no. The reality is anything but. In The Simple Path to Wealth, JL Collins notes, “In the February 2010 issue of The Journal of Finance, Professors Laurant Barras, Olivier Scaillet and Russ Wermers presented their study of 2,076 actively managed U.S. stock funds over the 30 years from 1976 to 2006. Their conclusion? Only 0.6% [of fund managers] showed any skill at besting the index or, as the researchers put it, the result was ‘…statistically indistinguishable from zero’” (76). How does a value proposition of skill that’s “indistinguishable from zero” sound to you? Not compelling, to say the least.
How does a value proposition of skill that’s “indistinguishable from zero” sound to you? Not compelling, to say the least.
And Many Others
This list is by no means exhaustive; I’ve only chosen to explore the areas of biggest benefit here. But there are others: no individual stock risk, minimal (to no) overlap in your portfolio, no sector risk, maximum diversification (we will explore this a bit later on), no style risk, low maintenance, easy of rebalancing, and so on. When you take a step back and evaluate the pros and cons of index investing compared to active investing, it quickly becomes apparent why the former is such a compelling strategy.
In Part 7, we are going to explore the three main types of index funds that our portfolio will be structured around; these represent the three asset classes that I believe all investors should consider when building a portfolio. See you there!
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