Would you believe me if I told you that there was a simple way to beat over 90% of professional managers over the next 15 years and beyond while simultaneously becoming an owner of many professional sports teams?

Well, it’s true. The pillar of this strategy is the index fund.

What are index funds?

Index funds track an index. For example, an S&P500 index fund tracks the S&P500, which consists of 500 of the largest companies in the United States. The S&P500 is a “market capitalization weighted” index fund, which means that it holds companies in proportion to their actual size. For instance, if a company makes up 4% of the S&P500, then the index would have 4% invested in that company.

Because index funds track an index, they are known as passive investments. In other words, a human being doesn’t have to make the decision about whether or not to buy or sell stocks within the fund.

These funds also don’t buy or sell stocks often. Since they hold companies in proportion to their actual size on the stock market, even as stock prices change, the fund is still holding the correct percentage of the company. The only time buying and selling is necessary is if a fund drops out of the index or if a fund is added to the index. This usually only happens to the smallest companies in the index, so only a tiny percentage of the fund is bought or sold each year. The buying and selling of stocks within the fund is known as fund turnover.

Vanguard was the first company to offer index funds, thanks to the guidance of Mr. John Bogle. At the time, index funds were known as “Bogle’s Folly”, but today, Bogle is known as the greatest champion of the individual investor for revolutionizing investing by providing index funds through Vanguard. In fact, Vanguard has a unique structure where the fund holders are also the shareholders of the company. Consequently incentives to cut costs are aligned between the owners and managers of the fund. In turn, lower costs lead to more money in the shareholders’ (your) pockets.

However, not all index funds are created equal. In addition to their unique structure, Vanguard funds, have no sales load (also known as commission), have rock bottom costs, have low turnover, and have efficient management due to their large size. These characteristics offer an advantage over other index funds.

Why index funds?

Why are index funds powerful?

Because index funds are passive, owners of these funds don’t have to pay fees to an expensive money manager. In addition, because they don’t buy and sell often and we are required to pay taxes and commissions when selling, they are very tax and cost efficient.

How efficient are they?

Here are the results of the index vs active management battle at the end of 2017:

Over the five-year period, 84.23% of large-cap managers, 85.06% of mid-cap managers, and 91.17% of small-cap managers lagged their respective benchmarks.

Similarly, over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis.

When you choose active management, you are making a bet that your manager will beat the market - a bet that is almost guaranteed to lose in the long run.

These results are from the S&P which also keeps track of which funds have disappeared. Accounting for the closed funds eliminates survivorship bias, which is when the return of funds are exaggerated because active managers conveniently leave out the funds that have ceased to exist. [1]

Since index funds track the benchmark, they also technically underperform ever so slightly due to their small expense ratio and tracking error. However, this underperformance is nearly negligible. For example, the Vanguard Total Stock Market Fund returned the same annual percentage (10.78%) as the benchmark index over the last 10 years and returned 6.86% annually since 2000 which was 0.02% less than the benchmark since the fund was offered in 2001. In absolute terms that is $2 less for every $10,000 invested. [2]

Outperformance

How and why do index funds perform so well?

In page 26 of Common Sense on Mutual Funds, John Bogle outlines the index fund advantage with a 3 sentence proof.

1. “All investors own the entire stock market, so both active investors (as a group) and passive investors–holding all stocks at all times–must match the gross return of the stock market.”

   • By definition, passive investors who hold the total stock market will earn the gross return of the stock market which is the return before fees, taxes, and costs. All the active investors together will also hold the total stock market since when you remove all the passive investors, the proportion of the market that each individual stock would make up does not change. In fact, the active investors determine the relative capitalization (size) of each individual stock based on how much they want to buy and sell.

2. “The management fees and transaction costs incurred by active investors in the aggregate are substantially higher than those incurred by passive investors.”

   • Active managers need to be paid for their work and so they charge fees. They also can’t hold every stock forever since they can’t justify their fees if they are just investing like an index fund so they generally have high turnover as well.

3. “Therefore, because active and passive investments together must, by definition, earn equal gross returns, passive investors must earn the higher net return.”

   • Since net return = gross returns - costs and gross returns are the same for both groups, the group with lower costs will end up with higher returns.

So how do active managers justify their services? They could claim that active investors includes both active managers and individual stock pickers and that the average return of individual stock pickers is much lower than the gross return of the total stock market. Thus, as a group, active managers should have a higher gross return. They could also claim they were one of the active managers that outperformed the stock market.

Is this true and if it is do their excess returns cover their costs? There is some truth to their claim that individual stock pickers perform worse. But outperformance of individual managers rarely persists and beats the fees charged which is why there are so few famous long term investors such as Warren Buffett in the world.

Peace of Mind

In addition to beating most active managers, index funds help me sleep at night. They eliminate the need to actively search for companies or analyze financial statements in order to invest. Buffett attributes his investing success to reading hundreds of pages of financial documents a day. I can buy and hold these index funds knowing that the index will self-cleanse as losers fall out of the index and reallocate the money to new up and coming companies automatically. I could ignore my investments for decades without losing sleep and without worrying about inflation ravaging the buying power of my investments.

The index would continue to self-cleanse unless a catastrophe wipes out the stock market. That would mean a complete collapse of the U.S. and world economy. At that point, the only portfolio allocation that will matter is water and ammunition anyways.

Although bonds are less volatile than stocks, I would lose sleep knowing that I would be losing out on massive returns in the long run. However, bonds do have a role in a balanced portfolio as we will discuss in On Bonds.

Awesomeness Factor

Finally, index funds allow us to own parts of many awesome companies. In fact, I sometimes joke that I’m a minority of owner of two NBA teams - the New York Knicks and the Toronto Raptors. The Knicks are owned by Madison Square Garden which is in the total US stock market and the Toronto Raptors are part of the total international stock market. In fact, I hold a part of most publicly traded companies. And by buying just one total world index fund or one total US market and one total international market fund, you could say the same.

Sounds Great but What are the Pitfalls?

There will be crashes and no one can accurately tell you when they will happen. How bad are these crashes? In 2008, the US stock market was down 57%. During the Great Depression, it dropped 89%. However, the most important thing is not to sell during these periods and continue buying in. If your investing is automated, then that’s even better. If you know that you cannot handle these drops, then choose an allocation that you are more comfortable with. For example, you could invest 50 percent into a stock index fund and 50% into a bond index fund. Just remember that you are trading long term returns for short term security especially if you are young and have many years ahead for your investments to grow. However, lower returns are justifiable if they prevent you from selling during the bear markets that will occur throughout your investing life.

The risks of investing in the stock market contributes to the greater return of stocks over safer investments such as bonds and savings accounts. This is because the stock market must provide greater returns, known as a risk premium, over these less risky investments to get investors to buy. However, owning an index fund that tracks a broad stock market index allows us to eliminate the risk of owning individual company stocks which have and will go bankrupt.

Once we realize that the market will crash and that we need to just continue holding on, we need to realize that the man or woman in the mirror is our most dangerous enemy. Fear of missing out causes people to jump in when the market is near it’s peak. Then loss aversion causes people to jump out of the market near the bottom of its dips. Despite the many who have tried, I have yet to see research proving that a person has succeeded in timing the market. In fact, managers that do well in rising markets may get burnt on the corrections and managers that outperform during the downturns might lose out on the market climbs. The best thing to do is to take our brains and thus our emotions out of the picture when making short term decisions. Create a long term plan and stick to it.

Simple Advice

Buy Vanguard index funds for the long run. Start with the total US stock market which is VTSAX. Do not try to time the market.

Resources

[1] SPIVA U.S. Year-End 2017

[2] VTSAX Performance

The case for low-cost index-fund investing