Why We Love Index Funds
Even Fancy Hedge Funds Lose to Index Funds
If you’ve read a bit of this site, you know that we LOVE index funds for our investing. For any novice, intermediate, or even expert investor they are the best way you can maximize your wealth over time. But what exactly is so special about index funds?
First, many people think they can successfully pick stocks. Many people are idiots. Let me tell you a story about a few of my friends. In undergrad, I majored in something called Operations, Research, and Financial Engineering (if that sounds like something that should be illegal, you’re probably right!). But it was a gleaming path to riches on Wall Street if you wanted them. Many of my friends ended up in big wall street banks and eventually made their way to big wall street hedge funds. And as a result, I have a bit of a window into that world.
They work insane hours, 100+ hour weeks. They devote horrendous amounts of energy and very expensive brainpower to the all-encompassing endeavor of picking stocks and other securities that will outperform what everyone else is buying. They literally have supercomputers that crunch endless reams of data trying to find patterns. There are armies of back office researchers and data scientists that poor over company information trying to get one tiny shred of advantage. Do you want to know how all those crazy expensive, high-flying hedge funds did over the last year? Absolute crap is being generous.
From Credit Suisse’s Hedge fund Index, the YTD return of all of these high-flying hedge funds was sitting around 0.09%. Compare that to our glorious index funds. An SP 500 index fund returned 7.84% YTD. Armies of Analysts, highly paid brains, and massive computers lost their shirt.
And the parade of horribleness extends back even further. There is a metric called a Sharpe Ratio, and Credit Suisse is kind enough to calculate it for all the fancy hedge funds. The Sharpe ratio is essentially a measure of the returns offered by a given investment relative to the risk of that investment, and it’s a helpful way to compare alternative investments that may not have the exact same risk profile: a guaranteed 5% is much better than a 50/50 chance at 0% or 10%. You don’t need to know the details, but for now, just know that a sharp ratio of about 1 is considered the bare minimum of acceptable. What did the hedge funds manage over the last 20 years? A Sharpe Ratio of .74 – that’s terrible.
So all of these fancy companies and all of my fancy smart friends can’t manage to pick the right stock to invest in if it came up and punched them in the face. What hope do you have? None, you have no hope. That’s my point. As smart as you think you are. As smart as you think your financial advisor is. You’re not that smart. Your advisor is not that smart. Unless you have a supercomputer in your basement, you and I have no prayer of picking stocks successfully on a regular basis, and even then we’d probably fair no better than my fancy friends and the hedge funds, which is pretty terrible. Always remember that on the other side of every stock trade you make there is a guy with 15 research analysts and a supercomputer. And even he isn’t winning. Neither are you.
However, the beauty is that we don’t have to try. We already have the perfect investment!
What are index funds?
Quite simply, an index fund is a type of mutual fund that tracks a specific set of companies. For instance, the SP 500 index I mentioned above is simply the 500 largest companies in the US by value. The value of the index is determined by the value of these companies. The Total US Stock market index is EVERY publicly traded company in the United States (around 4,000 today). There are index funds of every shape and size: indexes of small companies, indexes of large companies, international indexes, bond indexes, etc.
What they all share is something very simple. No one is actually trying to pick stocks, it’s completely passive. Index funds simply pick their index and track exactly how those companies behave in the market. There are no trades (other than the rare occasion of a new company being incorporated in the index), no one calling out that something is under or overvalued, no management at all.
Practical reasons for index funds
So why is this a good thing? Active management sounds great! I want someone investing my money in the best possible options. I want someone looking out for my best interests!
The first problem, they’re not looking out for your best interests. Most mutual fund companies are looking out for their shareholders or their owners best interest. They’re out to make a buck and every dollar that you give up is a dollar they pocket. Do you know why people keep opening hedge funds even though the performance is dismal? Because of something called the 2 and 20. Every hedge fund manager pockets 2% of the value under management and 20% of the profits from his fund every year. So they market them like crazy to dumb rich people and it works! It all adds up to a mind blowing a large amount of cash for the hedge fund managers. Companies like Fidelity and T Rowe Price are no different. They’re ultimately trying to squeeze every penny out of you that they can, and those expenses can have a huge drag on your returns over time.
The average mutual fund expense ratio (the % of your money that gets taken in fees every year) last year was 1.25%. It’s not the 2 and 20 of hedge funds, but this is still a huge number. Over a 20-year period, the difference in returns caused by these feeds adds up. A difference of just 1.25% over 20 years results in 20% less for your own retirement. On an initial $100k investment that works out to be a $70k difference. $70k that now belongs to the mutual fund company instead of allowing you to leave your job.
The beauty of index funds is that since there is not an army of analysts and stock pickers to pay to manage them, their fees are often dirt cheap. The current expense ratio on the Vanguard total stock market index fund is a whopping 0.05%.
But don’t those fees buy expertise? Don’t those fees deliver me higher returns in the long run? Nope and Nope. They buy you nothing, nada. You’d be better off lighting your money on fire and dancing around it into the night. You can read one of my favorite books from one of my favorite professors, A Random Walk Down Wall Street, for the full details of just how terrible it is. But it is terrible. Actively managed funds almost always underperform the market. So you’re basically paying more money for crappier results.
But wait! What if you really can pick one of those winners, one of that lucky 24% that were able to beat the market. The short answer is that you can’t. It’s simply impossible to predict the future performance of funds. There is a great study that comes out every year from Standard & Poor’s, that looks at the persistence of returns over time for mutual funds. The key finding is that of the funds in the ¼ of performers for any given year, only 7% managed to maintain that top ranking. Basically, the fund managers could have been throwing darts to pick stocks and they likely would have had a better chance of maintaining their top performance. So even if you happen to nab a lucky winner in one of those high-cost funds the likelihood that you’ll stay in that winner’s circle are vanishingly small.
Finally, there is one last benefit to index funds that puts them over the top (if you needed one more reason). Because of how they are managed (or not managed), index funds rarely trade the stocks that make up the fund. This results in VERY low turnover in their portfolios. When mutual funds buy and sell their stocks, they are forced to distribute out to investors the increase in the price of those stocks. If you’re holding these funds in a taxable account, you get taxed on these gains. Potentially at a very high rate if the fund has held the stocks for less than a year. The beauty of index funds is that due to their very low turnover they almost never sell any of their holdings, never distribute any capital gains, and save you a ton of money on taxes. For a very active fund that turns over its portfolio every year, this could mean you lose almost 25% of your returns to taxes.
Where do I find index funds?
So where do I find these magic unicorns? It’s very easy. If you’re shopping around for a company to set up an IRA, ROTH IRA or Taxable account then look no further than Vanguard. They’re the pioneer in Index funds; they offered the first one 40+ years ago. You can also find them offered by most large mutual fund companies at this point, but Vanguard’s are almost always cheaper. So if you have the misfortune of not investing with Vanguard you can either A) move your money to Vanguard or B) search for Index and look for low sub .1% fees in the funds your investment company does offer.
For your 401ks, in most circumstance the company managing your plan will have at least one low-cost index fund available, often one of the Vanguard or Fidelity funds. If your plan doesn’t offer any, raise hell with HR until they get one added.
What investments do you need?
Keep it simple! You really only need a couple index funds in any good portfolio. We have five because we’re extra fancy. But you can get by with three or even two. For the minimum level of complication, just have 2 and throw out the international stuff (USA! USA!). That’s it. You don’t need anything else.
- A total US Stock market index fund (or replace it with an SP500 index fund, they’re VERY similar in terms of overall performance)
- A total bond market index fund
- A Total International (Ex-US) index fund
Less Fancy Portfolio
- A total US Stock market index fund (or replace with an SP500 index fund)
- A total bond market index fund