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In Praise Of The Index Fund (And Why Others Can't Match Its Returns)

By Scott FearonStock MarketsSep 04, 2016 05:50AM ET
In Praise Of The Index Fund (And Why Others Can't Match Its Returns)
By Scott Fearon   |  Sep 04, 2016 05:50AM ET
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Wednesday marked the fortieth birthday of the most investor-friendly idea in stock market history: the index fund. Forty years ago Vanguard introduced the first fund that merely tracked the S&P 500. It has appreciated 6,334 percent since inception, trailing the S&P by a mere .14 percent annually, all of which was the ‘expense ratio’ charged investors. Few, if any other funds have matched or exceeded this annual return.

Today roughly $5 trillion is invested in index funds. Vanguard is the largest index manager, with over $3 trillion in assets under management (AUM). Other money managers now offer index products alongside their traditional, actively managed funds.

Study after academic study shows that index funds outperform most actively managed funds. The reason is simple. Fees. The average expense ratio for actively managed stock funds is around 1.5 percent. It is somewhat less for fixed income funds. As Vanguard founder John Bogle has convincingly shown, a fund with a 1.5 percent annual fee (and the same pre-fee annual return) will produce a much smaller total return over a multi-year period than a fund with a .14 percent annual fee.

Investors have taken notice. According to the Wall Street Journal, they have invested $409 billion in passive index funds in the last year and pulled $310 billion out of actively managed funds over the same period. Roughly 20 percent of all money in stock funds is now indexed, up from zero 40 years ago.

I suspect this trend will accelerate.

America’s economic growth and thus profit growth will likely remain below historic levels for years. Economists predict US productivity growth and population growth will continue decelerating (see Northwestern economist Robert Gordon’s recent book The Rise and Fall of American Growth). Given that interest rates are already at zero, this scenario all but guarantees future market returns will be lower than the S&P’s roughly 9 percent annual gain since the end of World War Two. As this occurs, the outperformance by index funds vs. the average actively managed fund will be much more pronounced than in previous years.

But don’t expect the asset management world to go down without a fight. A week ago, the reputable money management firm Bernstein issued a call to stem the indexing tsunami. The piece’s sensationalistic title—“The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism”—was obviously meant to attract media attention, and paint Mr. Bogle’s invention in the worst light possible. I’ve seen this kind of scare mongering in the asset management industry for three decades now. When I started out, indexing was still in its infancy, but people in my business were already shading the truth about it, and for good reason: it represented a major disruption to our industry. Rather than acknowledging the clear benefits of that disruption to the majority of investors, many folks have chosen to demonize and misrepresent it instead. As Upton Sinclair famously said: “It is difficult to get a man to understand something when his salary depends on his not understanding it.”

I have always believed that most mutual funds and most hedge funds will underperform the indexes on an after-fee, after-tax basis. Results over the decades prove this. But I have also believed (and continue to believe) that a small minority of managers can, and will continue to outperform. The managers who accomplish this feat employ varying investment strategies, but they almost always possess a similar combination of traits: an above average IQ, some years spent working at firms with above average performance results, intense intellectual curiosity, a cynical frame of mind, and a mistrust of groups and group thinking (great investors are not joiners).

As importantly, consistently outperforming managers almost always avoid growing assets under management beyond an amount where outperformance becomes more difficult. While the optimum AUM varies by manager and by style, it is almost always under $1 billion. Most managers who solicit assets beyond that amount are amoral at best, dishonest at worst. The reason sub-$1 billion funds have a better chance of producing higher returns is obvious: pricing inefficiencies are likely greater in less liquid, less analyzed securities. A number of stocks I have written about over the years illustrate these inefficiencies, including homebuilder LGI Homes (NASDAQ:LGIH) and apartment REIT Nexpoint Residential Trust (NYSE:NXRT). Both companies were barely followed by Wall Street when I visited with their managements, and far too small for larger funds to bother investing in—and both have far outpaced the indexes since I purchased shares.

A final warning to investors: as this industry disruption accelerates, the earnings, and stock prices, of asset management firms will likely disappoint. Some firms—those with low cost structures, low fees on actively managed funds, and a growing number of index funds/ETFs—will take marketshare and survive. But others may not. The list of publicly traded money management firms is lengthy. It includes household names like Franklin Funds, T Rowe Price, Legg Mason, Waddell and Reed, and Janus. Unless these firms adjust to the new index dominated world, their stocks could lag those very indexes for a very long time.

In Praise Of The Index Fund (And Why Others Can't Match Its Returns)
In Praise Of The Index Fund (And Why Others Can't Match Its Returns)

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