In recent years, there’s been an extended debate about the effectiveness of index investing versus active investing. That is, a debate over the wisdom of buying a basket of securities that represents some or all of a market versus trying to beat the market by actively choosing individual stocks.
It seems the indexers are winning the debate as index funds and equivalent exchange-traded funds keep gaining a greater share of the market. Enough interest, at least, to generate books about the subject.
In 2009, the iconic Dummies publishing company joined the fray with this book: “Index Investing for Dummies.” Its author was Russell Wild, MBA, who described himself as a NAPFA-certified financial advisor and principle of Global Portfolios, an investment advisory firm. Part of his motivation may have been revealed in the book’s sarcastic dedication:
“To Dennis, who in 1981 sold me 100 shares of the soon-to-go-bankrupt Continental Illinois National Bank and Trust Company. You were my first (and last) stockbroker, Dennis, and you taught me everything I ever needed to know about stock-picking.”
Chapter one began with a brief history of index funds, specifically, the idea John Bogle of The Vanguard Group developed. In 1974, he offered the first index fund and was greeted with scorn. Wild wrote, “In fact, the entire venture was slathered in mockery. 'Bogle's Folly,' it was called. 'Un-American'...'A sure way to achieve mediocrity.' Ha!”
As Wild noted, Bogle ended up with the last laugh as Vanguard had grown to become the biggest American fund company. He also credited Charles D. Ellis with helping justify early interest in indexing. Ellis did a study and wrote an article titled “The Loser’s Game” for the Financial Analysts Journal in 1975.
Among its findings: 85% of institutional investors failed to beat the S&P 500 in the previous decade. As for the title, “The Loser’s Game,” Ellis made the then-radical argument that winning had more to do with not making mistakes than with trying to beat the market.
Then there is the issue of costs:
- Management fees are much lower and the difference between them, when compounded in an index fund, add up substantially over the years.
- Other costs are lower, with no payments for research or advertising and no or lower costs for stock trades.
- Better taxation potential; because index funds infrequently buy and sell stocks, fewer capital gain liabilities arise.
- More honesty, “When you invest in an index fund, you won't find your fund managers looking for window dressing in December — those last-minute purchases made for the sole purpose of helping the fund's annual returns look better than they actually were.”
- Proven results. This is an interesting conclusion for a book published in 2009, in the immediate aftermath of the 2008 financial collapse and a plunge of 38.4% by the S&P 500. No doubt he was referring to long-term results (the author promises more on the subject in chapter three).
As a sub-headline observed, “Not All Indexing is Created Equal.” There are many kinds of index funds and having some knowledge may improve the choices. For starters, the “best” mutual funds will not be defined by what the fund does, but by what you need as an investor.
Once you have defined that need, you can begin to sift and sort the various index funds. Some are very broad, such as total market funds. The most popular are based on the S&P 500; these provide exposure to 500 of the largest American stocks, across a wide range of industries. Similar funds exist for major markets in other countries, for investors who seek foreign exposure. There are also bond index funds, which exist in parallel with stock funds.
Wild noted, “In general, the larger the index tracked by the index fund (in other words, the more securities represented by the index), the greater the diversification and the less the risk to you — but also the less potential return.”
Investors have an advantage if they understand the various divisions of indexes. For example:
- Market cap, from micro to large.
- Equal weighted versus fundamentally-weighted.
Also tackled: The argument that if you settle for index funds you settle for mediocre returns. But the author challenges that, writing, “Even a rather lazy index investor, one who picks his indexes willy-nilly, is still very likely to wind up in the top 40 percent of investors after 10 years, and the top 20 percent after 20 years.”
However, index fund investors will rarely be among the top 1% of investors. That honor will go to inside traders who manage to avoid jail, very lucky speculators and investing geniuses such as Warren Buffett (Trades, Portfolio).
Regardless of how well you do, Wild wrote you will enjoy several “virtues” if you index:
- Versatility: Whether you’re a conservative or aggressive investor, there will be funds or combinations of funds that should suit your exact needs.
- Profitability: Long term, your returns are likely to exceed those of investors who choose actively-managed funds.
- Taxation: The equities or bonds within index funds are held much longer, thus deferring capital gains and potential taxation.
- Simplicity: No great knowledge or skills are needed, though investors who learn more may earn more through better mixing of funds.
Wild closed the chapter with these words:
“In the Buddhist tradition, your patience and wisdom eventually allow you to become one with the entire universe. In index investing, patience and wisdom lead you to become one with the entire market. It's an exciting and potentially very rewarding journey that John Bogle first charted, and I look forward to taking you there!”
Read more here:
- Ă‚ The Dhando Investor: Indexing the Pabrai-Greenblatt Way
- The Dhando Investor: Guidelines for Selling Stocks
- The Dhando Investor: Be a Copycat, Not an Innovator
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