After the passing of Jack Bogle in 2019, the legendary founder of Vanguard index funds, it only seems fitting to address this topic here. The dual prongs of compounded costs in investing and the low chance of beating the market are the true merits of the index fund. An index fund does not seek to beat the market, rather it seeks to track the performance of the market. It does this by owning a large representative list of (a certain class like large cap or even total market) stocks in proportion to the market cap of the companies. An index fund can be low cost since it does not take any effort (cost) to figure out which stocks are worth owning (or to rapidly trade to adjust the portfolio). Rather it owns stocks indiscriminately in accordance with the market value and prominence of companies.
I have one obvious lesson and one less so obvious lesson to share in this regard. The cost of a managed fund around 0.5% higher a year say, might seem trivial at first. But when you consider that the fee is assessed on the entire investment and not on the returns, it becomes substantial. In a decent year in a low inflation environment, the return might be 5%, which means you are giving away 10% of your gains! Case in point, your money doubles every 14 years at 5%, but takes almost 16 years to double if the return rate is 4.5%! And the expense ratios of funds can be even higher than this, particulary in times past. Jack Bogle truly helped a generation of small investors and institutional accounts in the form of pension funds, retirement savings etc., keep more of their money.
The second lesson is this – index fund returns are way above most active fund returns!! You might wonder surely merely tracking the market would yield only average returns? This is true. But this is where the difference between average (mean) and median come in. The average return of the stock market is way above the median return. Index funds outperform around 80% of active fund managers in a given year. The other 20% have such spectacular returns for the year or a period of few years, while some of the trailing managers don’t do too badly compared to the benchmark. What is better, historical back testing studies have found that there is no consistency in which 20% of the managers beat the market over longer time intervals, in other words even the minority success in beating the market is not consistently repeatable.
(Sometimes I get a bit theoretically idealistic – If it was 100% repeatable, then they would get all the investment money in the market, putting other funds out of business, which would mean the old 20% minority becomes the whole market, but that is another story. Let’s say they refuse to accept all the nation’s wealth under their management for argument sake). Practically, as investors, choosing the active funds based on past performance is an insufficient metric, rather than current holdings/strategy. But that exercise transforms the investor into a manager himself, making the point moot! In short, index funds are a timeless invention that cuts people a better than fair deal, ever more important at a time of declining interest rates and hence possibly declining income from other sources.
Furthermore, some back data gets skewed since poorly performing funds are merged or closed and transferred to other funds, so the case based on acutal data is even better for index funds.The surviving outperforming funds will naturally tend to gravitate toward the benchmark or below (in other words everybody cannot be above average!). This last bit of analysis is a bit loose, since new funds enter the market too. But all in all, there is a reason Warren Buffett is famous. No one else has ever done it to such scale. And even if you invest in his fund today, future returns above the benchmark are hardly a guarantee.
Cars and Physics 