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The Case for Index Funds

by Tim Isbell, June 2017

Four facts

1. In 2015 only 40% of active managers beat the Russell 1000 (A large-cap U.S. stock index). The number for 2016 was just 20%. (see Renik link below, and just skip directly to the BofA histogram.)

2. Of the active managers who beat the indexes in one year, only about 5% do so for three consecutive years. (see Active Fund Managers Rarely Beat their Benchmarks Year After Year, by Tom Anderson.)

3. The entire net gain in the U.S. stock market since 1926 is attributable to the best performing 4% of listed stocks. The other 96% collectively matched the returns of one-month Treasuries. (See Bessenbinder link below.)

4. 58% of the CRSP common stocks (US Total Market Index) have lifetime holding period returns less than those of one-month Treasuries. (See Bessenbinder link below.)


Implications of the above Facts

There are several impediments against the long-term performance of active managers:

1. The higher expenses and fees that are inherent in active management. The cost of research and other things that go into an actively managed fund are significantly higher than for an index fund. See the link for detail. (Few retail investors understand the impact of fees and expenses - it's big.)

2. The increased taxation caused by high turnover. A couple of sources I checked said that the average turnover ratio for actively managed US stock funds is 89% and 130%. The first one means that 89% of the shares in the fund are sold and replaced with another kind of share each year. Compare that with the 4.1% turnover ratio of a typical S&P 500 index fund! Returns from the index fund are virtually all taxed at the low long-term gains rate, while the actively traded funds produce mostly short-term gains which are taxed as ordinary income. So not only does high turnover result in higher transaction costs that increase expenses within the fund, but it also significantly increases the taxes you pay for the returns you do get.  So, a $1000 return for an active fund gets taxed at a much higher rate than a $1000 return from an index fund. (Even fewer retail investors understand the impacts of taxation. That's big, too.)

3. The skewness described in Facts 3 & 4 (above). Skewness means there are very few "average stocks." While the index may have an 7%/year average (mean) return, the median return of the stocks hovers around zero. Skewness is a relatively new understanding in the personal finance arena. (I suspect that almost no retail investor understands skewness. And it is big, too.)  For more on skewness, check out these links:


My conclusion

Over any significant period, a portfolio filled with index funds will beat actively managed investments. So Robin and I invest in a low-fee, mostly index fund portfolio of stocks and bonds in an asset allocation that fits our risk tolerance. How low-fee? Currently, the expense ratio of our entire portfolio is 0.11%. And we rebalance back to our target asset allocation at least annually.

The resulting returns make sense to me. And we can sleep at night.


All the best,
Tim


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