Are Index Funds really as good as "experts" claim?

Question

I use the quotations because generally the people touting these the most (John Bogle) are also ones selling the index funds. Being biased doesn't mean they're wrong, but it does mean they may not be telling the whole truth.

I understand the idea that index funds are better than managed accounts. Lower fees, probably better returns, etc. etc., but generally when this topic is discussed those are the only two options considered as if they were the only investment options out there. I also agree that they probably make a lot more sense as "fire and forget" type investments for people to invest as passively as at all possible.

But are investment funds really all that much better than just buying stocks for long term investing? Index fund fees may be incredibly low, but they're still yearly fees. Whereas with a stock you can (in theory) purchase a significant ownership stake in a company for $5 and it will cost you another $5 to divest. (Oversimplification, I know.)

Also major index funds may represent a more diverse investment, also in theory, but take for instance the S&P500 where 50 companies make up about half the market cap.

Why would it not make more sense to invest in a handful of these heavyweights instead of also having to carry the weight of the other 450 (some of which are mostly just baggage)?

Even Warren Buffet has been touting the index fund for a while now, but I haven't heard that Berkshire Hathaway has major holdings in an S&P500 index fund. So it seems like there's more to the story.

Where do you think the tipping point really is here?

Edit: had to be away from the computer most of the day. Don't mean to insinuate at all that index funds are bad. Just questioning whether they're the right call for someone willing to be active enough to check their investments a few times a year.

Edit2: Just because it seems like some people may still be misunderstanding me... the comparison that this entire question revolves around is long-term, mostly passive invesments in companies rather than almost all the eggs in the index fund basket. This may be a better way to think about it rather than my question of picking stocks... ie: "[PickaCompany] has historically done pretty well, their business models seems pretty good, people like their product, I expect them to continue making profit for a while, they have a large customer base and a good share of the market in their industry, they seem like a good investment." Oversimplification by far, but it's generally these things that put companies in index funds and at the top.

Answer 1

I actually love this question, and have hashed this out with a friend of mine where my premise was that at some volume of money it must be advantageous to simply track the index yourself.

There some obvious touch-points:

• Most people don't have anywhere near the volume of money required for even a $5 commission outweigh the large index fund expense ratios.

• There are logistical issues that are massively reduced by holding a fund when it comes to winding down your investment(s) as you get near retirement age.

• Index funds are not touted as categorically "the best" investment, they are being touted as the best place for the average person to invest.

• There is still a management component to an index like the S&P500. The index doesn't simply buy a share of Apple and watch it over time. The S&P 500 isn't simply a single share of each of the 500 larges US companies it's market cap weighted with frequent rebalancing and constituent changes. VOO makes a lot of trades every day to track the S&P index, "passive index investing" is almost an oxymoron.

The most obvious part of this is that if index funds were "the best" way to invest money Berkshire Hathaway would be 100% invested in VOO. The argument for "passive index investing" is simplified for public consumption. The reality is that over time large actively managed funds have under-performed the large index funds net of fees. In part, the thrust of the advice is that the average person is, or should be, more concerned with their own endeavors than they are managing their savings. Investment professionals generally want to avoid "How come I my money only returned 4% when the market index returned 7%? If you track the index, you won't do worse than the index; this helps people sleep better at night.

In my opinion the dirty little secret of index funds is that they are able to charge so much less because they spend $0 making investment decisions and $0 on researching the quality of the securities they hold. They simply track an index; XYZ company is 0.07% of the index, then the fund carries 0.07% of XYZ even if the manager thinks something shady is going on there.

The argument for a majority of your funds residing in Mutual Funds/ETFs is simple, When you're of retirement age do you really want to make decisions like should I sell a share of Amazon or a share of Exxon? Wouldn't you rather just sell 2 units of SRQ Index fund and completely maintain your investment diversification and not pay commission? For this simplicity you give up three basis points? It seems pretty reasonable to me.

Answer 2

Why would it not make more sense to invest in a handful of these heavyweights instead of also having to carry the weight of the other 450 (some of which are mostly just baggage)?

First, a cap-weighted index fund will invest more heavily in larger cap companies, so the 'baggage' you speak of does take up a smaller percentage of the portfolio's value (not that cap always equates to better performance). There are also equal-weighted index funds where each company in the index is given equal weight in the portfolio.

If you could accurately pick winners and losers, then of course you could beat index funds, but on average they've performed well enough that there's little incentive for the average investor to look elsewhere.

A handful of stocks opens you up to more risk, an Enron in your handful would be pretty devastating if it comprised a large percentage of your portfolio. Additionally, since you pay a fee on each transaction ($5 in your example), you have to out-perform a low-fee index fund significantly, or be investing a very large amount of money to come out ahead. You get diversification and low-fees with an index fund.

Answer 3

Picking yourself is just what all the fund managers are trying to do, and history shows that the majority of them fails the majority of the time to beat the index fund. That is the core reason of the current run after index funds.

What that means is that although it doesn’t sound so hard, it is not easy at all to beat an index consistently. Of course you can assume that you are better than all those high-paid specialists, but I would have some doubt. You might be luckier, but then you might be not.

Answer 4

The point of buying an index fund is that you don't have to pick winners. As long as the winners are included in the index fund (which can include far more than 500 stocks), you benefit on average because of overall upward historical market performance. Picking only the top 50 capitalized stocks in the S&P 500 does not guarantee you will successfully track the S&P 500 index because the stocks in the tail can account for an outsized amount of overall growth; the top 50 stocks by market capitalization change over time, and these stocks are not necessarily the stocks that perform better.

As direct example, the 10 year average annual return for the S&P top 50 is 4.52%, while the 10 year average annual return for the S&P 500 is 5.10%. Issues of trading and balancing to maintain these aside, these indices are not the same.

Answer 5

Two main points to answer this in my opinion. First, most people don't start with say half a million dollar to buy all the stocks they need in one shot but rather they accumulate this money gradually. So they must make many Buys in their lifetime. Similarly, most people don't need to withdraw all their investment in one day (and shouldn't do this anyway as it cuts the time of investment). So there will be many Sells. Performing a single buy or sell per year is not efficient since it means you have lots of cash sitting doing nothing. So in this sense, low cost indexing lets you quickly invest your money (and withdraw it when needed after say you retire) without worrying about commission costs each time.

The second and most important point to me to answer this is that we should make a very clear distinction between strategy and outcome. Today's stock prices and all the ups and downs of the market are just one possible outcome that materialized from a virtually uncountable number of possible outcomes. It's not too hard to imagine that tomorrow we hear all iPhones explode and Apple stock comes crashing down. Or that in a parallel universe Amazon never takes off and somehow Sears is the king of online commerce.

Another item in the "outcome" category is your decisions as a human being of when to buy and sell. If that exploding iPhone event does occur, would you hold on to your stocks? Would you sell and cut your losses? Does the average person make the same decision if they had $1000 invested in Apple alone vs $1M?

Index investing offers a low cost strategy that mitigates these uncertainties for the average person. Again here the key is the word "average". Picking a handful of the heavyweight stocks as you mention might give you better returns in 30 years, but it could just as easily give you worse. And the current data suggest the latter is more likely. "Heavyweights" come and go (who were they 30 years ago?) and just like how the other 450 companies may seem right now as dragging down the portfolio, just as easily a handful of them can emerge as the new heavyweights. Guaranteed? No. Possible? Yes.

Jack Bogle is simply saying low cost indexing is one of the better strategies for the average person, given the data. But nowhere is it guaranteed that in this lifetime (e.g. next 30 years) will provide the best outcome. Berkshire on the other hand are in the business of chasing maximum outcomes (mid or short term returns). It's two different concepts that shouldn't be mixed together in my opinion.

Answer 6

Comparing index funds to long-term investments in individual companies? A counterintuitive study by Jeremy Siegel addressed a similar question: Would you be better off sticking with the original 500 stocks in the S&P 500, or like an index fund, changing your investments as the index is changed? The study: "Long-Term Returns on the Original S&P 500 Companies"

Siegel found that the original 500 (including spinoffs, mergers, etc.) would do slightly better than a changing index. This is likely because the original 500 companies take on a value (rather than growth) aspect as the decades pass, and value stocks outperform growth stocks.

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Index funds' main strength may be in the behavior change they induce in some investors. To the extent that investors genuinely set-and-forget their index fund investments, they far outperform the average investor who mis-times the market. The average investor enters and leaves the market at the worst times, underperforming by a few percentage points each year on average. This buying-high and selling-low timing behavior damages long-term returns. Paying active management fees (e.g. 1% per year) makes returns worse.

Returns compound on themselves, a great benefit to the investor. Fees also compound, to the benefit of someone other than the investor.

Paying 1% annually to a financial advisor may further dent long-term returns. But Robert Shiller notes that advisors can dissuade investors from market timing. For clients who will always follow advice, the 1% advisory fee is worth it.

Answer 7

Here is my simplified take: In any given market portfolio the market index will return the average return on investment for the given market.

An actively managed product may outperform the market (great!), achieve average market performance (ok - but then it is more expensive than the index product) or be worse than the market (bad).

Now if we divide all market returns into two buckets: returns from active investment and returns from passive investments then these two buckets must be the same as index return are by definition the average returns. Which means that all active investments must return the average market return.

This means for individual active investments there are worse than market returns and better then market returns - depending on your product. And since we can't anticipate the future and nobody would willingly take the "worse than market" investment product, the index fund comes always up on top - IF - you would like to avoid the "gamble" of underperforming the market.

With all these basics out of the way: if you can replicate the index by simply buying your own stocks at low/no costs I don't see any reason for going with the index product beyond the convenience.

Answer 8

Simply put, you cannot deterministically beat the market. If by being informed and following all relevant news, you can arrive at the conclusion that company A will likely outperform company B in the future, then having A stocks should be better than having B stocks or any (e.g., index based) mix of them. But as the whole market has access to the very same information and will arrive at the same conclusion (provided it is logically sound), "everybody" will want A stocks, which thus become expensive to the point where the expected return is average again.

Your only options of winning this race are to be the very first to have the important information (insider trade), or to arrive at different logical conclusions than the rest of the world (which boils down do making decisions that are not logically sound - good luck with that - or assuming that almost everybody else is not logically sound - go figure).

Answer 9

I'm really intrigued by this question, as I've often thought along similar lines. There seem to have been some disagreements over exactly what @dcg1000 is asking, so hopefully I've understood correctly, and am not just projecting my thoughts onto their question.

It seems logical that one could avoid the annual fees charged for passive fund management by directly buying shares in a diversified range of companies. If someone had the resources to buy all the shares in an index, they could reproduce its performance and cut out the middle man (Vanguard, Blackrock etc). If someone has fewer resources, they could buy a subset of the index. I imagine that the subset of the index would have a similar expected performance to the index, since nobody knows in advance which stocks in the index are going to perform well. The actual performance might be better, or it might be worse. The downside of investing in only a subset of stocks, is that they will be less diversified and hence more volatile. In the extreme case, investing in just one company could go very well, or it could go very badly.

So I made a little program to compare investing in an ETF and investing in a basket which is a subset of that ETF. The differences are the fee structure and the volatility. I have uploaded the code to https://repl.it/@craq/compareETFwithabasketoffundspy. You can go and play with the numbers and see if you agree with my assumptions. Any feedback welcome! Here are a couple of graphs that came out of running the simulation 500 times for an ETF and a basket, with an upfront investment of $100k and ongoing investments of $10k per year over 50 years (based on my impression that @dcg1000 had some funds to invest now, and an above average income):

• ETFs with fees below 0.1% e.g. VOO, IVV are tough to beat. The average performance of the basket is marginally better, but the difference is much smaller than the spread, so it doesn't seem worth the effort.
• as fees rise above 0.25% the distributions separate, and there appears to be an advantage to buying a basket of shares directly.
• until your investment gets up around $100k, the flat rate of transaction fees for rebalancing is actually more expensive than the ETF management fees.
• above $100k, the volume of the investment did not appear to make much difference to the result, which surprised me.
• holding the investment for longer makes the ETF less attractive. I used a timeframe of 50 years to represent investing for retirement. If you have to access your funds after only 10 years, you won't have time to save back the upfront transaction fees of buying all those different shares. If you intend to pass the shares on in an inheritance, the timeframe could potentially be more than one lifetime.

There are some caveats to this calculation

• I haven't taken the buy-sell spread into account. Managers of large funds may be able to achieve a better buy-sell spread, or they may be penalised since buying/selling large amounts may saturate the market, especially when the timing is predictable based on index policy.
• the transaction fee is assumed to be constant over a large time frame. In reality, it may be subject to inflation, or it may decline due to improved technology.
• lots of the numbers are very rough estimates. I think the calculation is mostly useful as a sensitivity analysis. For example, the annual return is actually not very important for choosing whether to use an ETF or not, whereas volatility is.
• if you're picking shares as a subset of an index, you can include "environmental, social, governance" factors into your choice of shares, so as not to support fossil fuels, weapons manufacturers or whatever your preference may be. Of course, you should be careful not to end up picking stocks based on your expectation of their financial performance, as that would go against the principle of passive investment.

Answer 10

A lot of it boils down to these key points:

• Index funds are generally highly diversified and reduce risk compared to individual stocks.
• The investment world is highly unpredictable, but the one variable you can control is the fees on funds. Even if index funds perform exactly the same as a managed fund, an extra 1-2% return per year compounded can really improve your returns.
• Assuming a managed fund could consistently outperform the indexes, it might be worth paying more fees. However, there are very few examples of funds that have been able to do that over the long term.