• Thu. Jan 21st, 2021

Investing In Index Funds Why Its The Best Option

Investing In Index Funds Why Its The Best Option why the index fund is the best option for the individual investor!

The biggest benefits that investors receive when you invest via an index portfolio include; reduced costs, increased or complete diversification, style purity, asset allocation consistency, and, usually, the close tracking of the market rate of returns.

Index FundManger
Reduced costsDependent on speculation and risk of manger
Complete diversification Concentration of assets in unrewarding sector
style is consistent always completed diversificationSubject to managers drifts and whims
Peace of mindStress
The Math Of Index Funding

Nobel prize-winning economist William Sharpe in his article, The Arithmetic of Active Management, argues that the simple mathematics of investment costs are fundamental to the logic of index fund investing.

“The cost matters hypothesis is all that is needed to explain why indexing works: gross return in the market as a whole, minus the costs of obtaining that return, equals the net return investors actually receive.”

In today’s world with the ability for investors to purchase low-cost index funds from investment companies as Vanguard, Fidelity, Charles Schwab,  Blackrock iShares, and SSgA where there is practically no management fee and active management funds can charge astronomical fees read Passive Or Active Investing Which Way Will You Earn More for more info.

The virtues of index fund investing will become clearer with a long-term perspective on performance.

Low Costs Index Funds The Arithmetic

The index funds’ cost advantage over higher-cost actively managed leads to a higher compounding of investment returns and a lowering of the corrosive compounding of investment costs.

The table below shows the after-cost performance of a low-cost index fund, with total management and trading expenses of 0.20% per year, with the 2.50% annual management and trading costs of the average active fund.

The market return for an initial $10,000 investment in the stock market in 1980 and held until 2005  grew to a value of $179,200.

The index fund grew to $170,200 compared to the average active fund’s growth to $98,200.  The after-inflation values come to $76,200 for the index fund; $40,600 for the average actively managed fund.

Activly Managed Funds

An investor desiring to invest for the long term say for 15-30 years such as for retirement faces a number of challenges when choosing a mutual fund.

A fund might disappear either by being shuttered or by a merger with another fund and either having to start his search all over or being invested in an area that he did not choose. After all, it’s all up to the manager.

The fund’s investment manager can leave the fund, either to pursue another management job or by being dismissed for lackluster performance.

An investor wishing to hold small-cap value stocks might find that the fund has shifted its investment focus to mid-cap growth stocks (or vice versa), thus confounding the investor’s desired asset allocation decisions.

Standard and Poors examine mutual fund survivorship and style consistency.

Over one-year periods, approximately 5% of all mutual funds cease to exist. The percentage of defunct funds rises to approximately 22% over five-year periods and 39% over ten year periods.

Standard and Poors found that nearly 18% of mutual funds shift styles over one-year periods, approximately 33% shift styles over five years, and 52% over ten year periods.

In a research paper, You’re Fired! New Evidence on Portfolio Manager Turnover (2011),  researchers Leonard Kostovetsky and Jerold B. Warner examines mutual fund manager turnover.

Shockingly between the years of 1995 to 2009, the annual rate of mutual fund manager turnover averaged 18.7% of all mutual funds.

Standard and Poors Index versus Active reports

Survivorship (All funds)Survivorship (All funds)
1 year5.14%
3 years13.37%
5 years22.54%
10 years39.44%
Style Consistency (All funds)Style Consistency 2008-2018
1 year17.88%
3 years23.94%
5 years32.57%
10 years51.79%

Index Funds Mitigate These Risks

Broad-based index funds with established asset bases such as unions etc, that give them money to invest can be expected to survive for decades, take a look at Vanguard. Vanguard regarded as the Walmart of Mutual Funds Index Funds and has been around for 1975 over 45 years ago.

Index funds are managed by investment management teams not just an individual. Their goal is to concentrate on efficiently transacting the securities that are predefined by the index. Since they are not exploring new areas for investment the loss of a manager should have little effect on the management of the fund.

As mentioned above an index fund is designed to track a given index. A US total market stock index will only hold US stocks; an international stock index will hold international stocks. A large-cap index fund will hold large-cap stocks, a small-cap will hold only small caps. This enables you as an investor to target your targeted market and your investment will remain there.

Performance Probabilities

Rick Ferri, CFA, and Alex Benke, CFP, have examined the performance probabilities of various index portfolios versus actively managed portfolios in their award-winning white paper, The Case for Indexed Portfolios (see note).
The chart illustrates the study findings for the relative performance of US large-cap equity funds and the Vanguard total stock market index fund (1997 -2012).
Over this period, the index outperformed 77.1% of active funds. The results of the outperforming active funds are also skewed, with the median outperformance equaling +0.97% and the median underperformance equaling -2.01%.

VTSMX (US equity: 40%)77.1%-2.01% 0.97%
VGTSX (Int’l equity: 20%) 62.5%-1.75% 1.34%
VBMFX (US bonds: 40%)91.5% -0.99% 0.23%
Weighted 40%/20%/40% 79.9%-1.56% 0.74%
Scenario 1 Results 82.9%-1.25% 0.52%
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Binyomin Terebelo

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