Indexing – Not as Easy as It Seems

With practically every area of the market up significantly this year, the appeal of index funds has been growing as well. Investors are attracted to the broad diversification, low cost, and tax efficiency index funds provide, and as a result, flows into index strategies eclipsed $1.6 billion in 2017 and 2018, according to Forbes. In the first quarter of 2019, Vanguard alone accounted for nearly half of all fund inflows, more than its three largest competitors combined! ¹

A simple way to sum up index investing is to quote Jack Bogle, Founder of Vanguard: “Don’t look for the needle in the haystack. Just buy the haystack!”² In other words, by owning entire asset classes versus trying to pick a handful of winners, you have a better chance of success. While not glamorous or exciting, slow and steady wins the race.

BDF also believes in diversification and long-term investing, and there are many things we like about index funds. However, it’s important to note that while index investing may appear easy, the evidence suggests otherwise. For example, with a plethora of index funds at their disposal, the average investor only made 1.9% annualized per year for the last 20 years, underperforming every area of the market including cash. This doesn’t even account for taxes.

There are many explanations for this:

1. There are now more indexes than stocks.

According to Bloomberg, the number of market indexes now exceeds the actual number of stocks³. That said, the number of ETFs and mutual funds tracking these indexes are in the thousands and growing. How should you know which one to choose?

This is where it gets tricky because the big misconception is that indexes and the funds tracking them are pretty much all the same. This couldn’t be further from the truth.

2. Not all indexes are the same or have good performance.

For example, let’s say you want to buy an index fund that invests in US small-cap stocks. Seems simple enough, but which one do you buy? The iShares Russell 2000, the Vanguard Russell 2000, or do you buy the iShares S&P 600 or the SPDR S&P 600? None of the above? Does it matter?

Yes, it does. For instance, there is a 40% difference in cumulative returns between the Russell 2000 and S&P 600 from 9/16/10 through 7/29/19 (9/16/10 is the inception date for the Vanguard funds).

There is also a 4.4% cumulative difference between the iShares and Vanguard Russell 2000 funds. On a $100,000 investment, that’s a $4,000+ difference, and this is between two reputable funds tracking the same index, mind you.

3. Not all index funds are tax efficient.

Investors in the Dreyfus S&P 500 found this out the hard way in 2018 when the fund experienced an enormous 12.8% distribution. On a $100,000 investment, this translated into a $12,800 taxable distribution, in a year when stocks lost money. While it may have looked like any other S&P index fund, Dreyfus clearly was not.

4. Not all indexes tilt toward factors that are more likely to outperform.

Tilting toward certain low-cost factors can enhance returns over time. However, most traditional indexes simply own the entire asset class. For example, profitable companies have outperformed unprofitable companies by a wide margin based on the research of Robert Novy-Marx and Dimensional Fund Advisors, but not all companies in the S&P 500 index, for example, are profitable. By selecting strategies that weed out unprofitable companies, a much better long-term result can be achieved.

The above simply reiterates that taking an index approach requires careful skill, discipline, and the right decision-making resources to be successful. Short cut any of these, and you could very well end up with a less than desirable performance.