Index Funds and Passive Fund Management: Understanding the Opportunity

There is a more cost-effective way to invest your money. Are you taking advantage of it?

In my most recent post, Expense Ratio - The Fee That You Will Never See!, we walked through how you can figure out what you are paying for your mutual funds as well as the total fees paid to have your money invested. To provide an alternative solution to the higher-cost investment options available to you, allow me to introduce (or re-introduce) you to Index Funds.

What is an Index Fund?

An Index Fund can be either a mutual fund or an exchange traded fund. The primary difference between an index fund and a traditional active mutual fund is that it’s designed to track the performance of a market index like the S&P or Dow Jones Industrial Average. For example, if you own an S&P 500 Index Fund like the Charles Schwab S&P 500 Index (SWPPX), and the S&P 500 is up 1% on the day, your holding of SWPPX should also be up 1%.  And what makes index funds particularly attractive to investors are their characteristically low operating costs. In the case of SWPPX, the expense ratio is just .03%.

What is Passive Fund Management?

Passive fund management is a portfolio management style/investment strategy where a manager uses index fund to invest. The manager doesn’t attempt to beat the market through active investing strategies of buying and selling securities within investor portfolios. Instead, passive investing focuses on buying and holding index funds through market fluctuations without attempting to anticipate future market performance.

Understanding the history of Index Funds and Passive Management

The very first Index Fund was created on December 13, 1975, by Jack Bogle of Vanguard.[i] He created this new investment vehicle because he came to realize that the majority of actively managed mutual funds and asset managers were not outperforming the market, despite repeated attempts, and that the costs associated with active management were high.

Traditionally, active money managers sold investors on the idea that they could outperform the market and, in turn, yield their clients a higher return than anyone else. Investment managers believed (incorrectly) that they somehow could predict the market. As an example, if the Dow Jones Industrial Average is up 7 percent for the year, an active manager may believe he or she can pick the best-performing stocks in the index while simultaneously avoiding the under-performing ones, thus earning higher than a 7% return. Since an index like the Dow Jones Industrial Average is just an average of the performance of all the underlying stocks, some stocks will earn higher than 7 percent and some will under less than 7 percent. So active managers are betting that they can predict the winners and losers.

Why Index Funds?

To get Vanguard to adopt the index fund, Bogle presented data to show how $1 million invested with an assumed market return of 10 percent would be worth $17.5 million after 30 years. Meanwhile, a similar investment at 8.5 percent (using the 1.5 percent cost differential) would be worth $11.5 million. The point he illustrated was that the cost-savings resulted in a $6 million payoff that was six times the original amount of the initial investment. Vanguard saw the opportunity and approved the index fund Jack Bogle created.

The Big Idea: The less money spent on fees means more money that can stay invested in the market and grow over the long-term.

Today, many investment managers still follow the active investment philosophy and try and “beat the market” by earning a better return. The wealth of data and research that exists now shows individual investment advisors cannot outperform the market in the long-run.[ii]

The truth is, no one knows with certainty where the market is headed on a daily, monthly, or yearly basis. You can always find an example of an active investment manager who beat the market for a year or two. But it’s nearly impossible to find evidence of any manager doing so on a consistent basis over the decades of time that most people invest.

Conclusion

Index funds make up anywhere from 25 to 30 percent of all fund investments. These funds mirror an index at a fraction of the cost of a traditional mutual fund that tries to outperform the index.

If you haven’t yet, it’s time to rethink the high cost and poor performance of actively managed mutual funds. But if the data isn’t enough to convince you, the lower cost of investment management just might. Index funds are an opportunity for every investor. Take a hard look at what you are paying for and ask yourself: Is it worth it?

[i] https://www.vanguard.com/bogle_site/lib/sp19970401.html

[ii] S&P Dow Jones Indices, “SPIVA® U.S. Scorecard,” Aye M. Soe, CFA® and Ryan Poirier, FRM, July 2017. http://www.spindices.com/documents/spiva/spiva-us-mid-year-2017.pdf