Indexing – Not as Easy as It Seems

August 22, 2019

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.

Source: Ycharts

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.

1 “Vanguard sees nearly half of all fund inflows in first quarter”, InvestmentNews, April 18, 2019; “Cash Flows Into Vanguard, Blackrock; Out Of Invesco, Franklin Templeton & Dreyfus”, Forbes, February 28, 2019.

2John C. Bogle, The Little Book of Common-Sense Investing.

3 “There are Now More Indexes Than Stocks”, Bloomberg News, May 12, 2017.

Past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk.  Future performance of any investment or wealth management strategy, including those recommended by Balasa Dinverno Foltz LLC (BDF), may not be profitable, suitable for you, prove successful or equal historical indices.  Historical indices do not reflect the deduction of transaction, custodial or investment management fees, which would diminish results.  Any historical index performance figures are for comparison purposes only and client account holdings will not directly correspond to any such data.  BDF clients must, in writing, advise BDF of personal, financial or investment objective changes and any restrictions desired on BDF’s services so that BDF may re-evaluate its previous recommendations and adjust its investment advisory services.  BDF’s current written disclosure statement discussing advisory services and fees is available for review at www.BDFLLC.com or upon request.

The S&P 500 Index includes a representative sample of the largest 500 companies in the U.S. The Russell 2000 Index® measures the performance of the 2,000 smallest companies in the Russell 3000 Index.

The S&P 600 is an index of small-cap stocks managed by Standard and Poor’s. It tracks a broad range of small-sized companies that meet specific liquidity and stability requirements. This is determined by specific metrics such as public float, market capitalization, and financial viability among a few other factors.