Low Cost Index Funds And Low Fees vs. Actively Managed Mutual Funds
“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” — Warren Buffett
What does it all mean? What does it mean to be an investor in today’s day and age? What is an investor? What do these so called individuals invest in? You might even be asking yourself, “Should I invest?” If so, where should I put my money and why should I put it there. By no means am I soliciting advice or represented to talk about one fund or philosophy more than the other. I’m simply the messenger and educator here! As a reminder, since 2000 we’ve lived through two recessions in the .dotcom bubble and the real estate and mortgage backed crisis of 2007 and 2008. When’s a downturn going to happen next? Whose to say it won’t affect you? Are you going to be prepared?
Jack Bogle is a well known innovator within the financial services industry. He advocated for low cost index fund and low fees and prior to that did his Princeton University thesis in 1951 on the impact of fees and trying to beat the stock market, which ultimately led him to found The Vanguard Group and bring the first index fund to the market in 1976 known today as Vanguard 500 index fund (VFINX). Fees may not seem like much in the beginning of investing when balances are low and expense ratios are 1% to 2%, but they are extremely detrimental as time and account balances grow.
As previously mentioned in 1951, Bogle wrote his Princeton senior thesis on mutual funds, “The Economic Role of the Investing Company.” He said mutual funds can make no claim to superiority over the market averages. When looking anecdotally at a bunch of funds, pretty much large-cap Dow Jones Industrial Average (DJIA) kinds of funds, he could not see that they were out-managing the market. When Bogle started Vanguard in 1974, he was rather unique in the annals of the mutual fund industry because the people who invested in the funds (the fund’s shareholder) also owned the management company with Vanguard Group.
So we’re all probably wondering, how will indexing affect the mutual fund industry? Fund managers are worried. Last fall, a group of active managers got together in New York to figure out what they can do to stop the trend toward index funds. Fund companies know it’s virtually impossible to beat the market over the long run. Because of that, the amount of cash in mutual funds will start to dwindle. Over the next decade, many will go out of business, merge with somebody else or sell their companies. This is a tidal wave — a tsunami — and it’s not going to stop. As other concepts out there today, it’s an idea whose time has come.
As a quick side note, and not to get off the beaten path, I always like to talk about what I’m reading or great books in the past which I’ve read. Some of my favorite investment books are Burton Malkiel’s A Random Walk Down Wall Street. He comes to the same conclusion that Jack Bogle did — that indexing is the way. Bogle’s Little Book of Common Sense Investing says pretty much the same thing. Another great book is Money Master The Game by Tony Robbins which I would recommend to anyone making 6 figures or more a year and wondering what to do with their money. As well as from a fee-conscious perspective and general approach and insight from some of the smartest financial minds in the world, I would highly recommend it!
So What Is An Index?
An index is an un-managed collection of securities designed to reflect the properties, returns, and risk parameters of a specific segment of the market. An index is a theoretical construct: You can’t buy shares directly in an index, but you can buy shares of the companies that are included in the index. As an example, Vanguards 500 index fund (VFINX) tracks the movement of the S&P 500. The Standard & Poor’s 500, often denoted by S&P 500, is the American stock market index based on the market capitalizations of 500 large companies having common stock listed on the New York Stock Exchange (NYSE) or NASDAQ.
What Is An Index Fund?
Index funds are still mutual funds, arrangements in which you pool your money with other investors. And you still have an investment company that handles your transactions. The difference is that the investment company isn’t paying a fund manager and a team of financial analysts to try to cherry-pick stocks and bonds. Instead, the fund cuts out the middlemen, saves the investors their time and money, and just buys everything in the particular index it aims to replicate. This index could track stocks, bonds, or REITs, for example.
What Is A Mutual Fund?
A mutual fund is simply an arrangement in which a group of investors pool their money together and hire a professional money manager to buy and sell securities on their behalf. The typical arrangement is for the money manager (or his company) to take an investment fee out of the assets of the fund each year — typically between 0.5% and 1.5%. It is referred to as an expense ratio, and comes directly out of your account as a proportion of your assets.
The investment company takes this money and uses it to take care of overhead, office expenses, marketing, and to pay a custodian to handle transactions. The money also pays a salary to the fund manager and a team of analysts that helps the fund manager pick and choose stocks, bonds, and other securities to buy and sell. When you have a manager (or team of managers) that actively buys and sells selected securities in order to maximize return, minimize risk, or both, that approach is called active management.
But what if you didn’t need to pay a team of analysts to sit around all day and analyze securities? Could you pay a lower expense ratio? It turns out you can, via a special kind of mutual fund called an index fund.
The funny thing is that a lot of these mutual fund managers don’t necessarily 100% believe in the product or service they’re offering because their personal money is actually in these low-cost index funds. Clearly they won’ t come out front and say that right away. It’ll probably take a few drinks in them first before they do…
So What’s the difference? It’s based on your investing style.
Index and actively managed funds each have unique benefits that you’ll be able to use to your advantage. It all comes down to how you want to put your money to work for you.
Index Funds: Try to track the performance of a particular market benchmark — or “index” — as closely as possible.
Actively Managed Funds: Try to outperform their benchmarks and peer group average.
Index Funds: Buy all (or a representative sample) of the securities in the benchmark.
Actively Managed Funds: Combine research, market forecasting, and the experience and expertise of a portfolio manager or management team.
Other things to consider
Index Funds: Index funds tend to be more tax-efficient and have lower *expense ratios than actively managed funds because they generally trade less frequently.
Actively Managed Funds: Though they attempt to beat the market, these funds can also miss their goals, resulting in losses for the fund — and its investors.
*Vanguard average expense ratio: 0.19%. Industry average expense ratio: 1.03%. Sources: Vanguard and Lipper, a Thomson Reuters Company, as of December 31, 2015.
*For the 10-year period ended December 31, 2016, 10 of 10 Vanguard money market funds, 51 of 54 Vanguard bond funds, 23 of 23 Vanguard balanced funds, and 99 of 110 Vanguard stock funds — for a total of 183 of 197 Vanguard funds — outperformed their Lipper peer-group average. Results will vary for other time periods. Only mutual funds with a minimum 10-year history were included in the comparison. Source: Lipper, a Thomson Reuters Company. The competitive performance data shown represent past performance, which is not a guarantee of future results.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Yes, Vanguard provides services to the Vanguard funds and exchange traded funds (ETFs) at cost. They have to make a profit. That’s rather straightforward. At least they’re much more transparent and not ripping you off like money actively managed funds out there. Need I say more about the big funds or banks. However, I digress and will save my breath and fingers.
To paraphrase all of the mumbo-jumbo that I probably lost a few of you on comes down to this, we must approach investing by simplicity and common sense. Do not, I repeat DO NOT, get your emotions involved when it comes to investing for the long term.
Below are 8 rules investors should generally approach or look further into, especially when starting at a young age. Say for example 22, 23, 24 or 25. However, if you’re in your 30’s and 40’s that’s great too. Simply understand that starting late in life will mean having to play catch up and miss out on compounding interest, one of the greatest inventions of all time.
- Select low-cost funds
- Consider carefully the added costs of advice
- Do not overestimate past fund performance
- Use past performance to determine consistency and risk tolerance
- Beware of stars (as in, star mutual fund managers)
- Beware of asset size
- Don’t own too many funds (keep it simple)
- Buy your fund portfolio — and hold it for the long term (which means more than 10 years)
Thank you very much for reading and sticking with me this week as this was a topic of heavy consideration. I suggest making use of Google, YouTube and Netflix to find financial topics you’re also passionate about. The complexity in the financial services industry leaves people believing this isn’t something fit for them. However, in the end, investing is something we can all do ourselves, read further up on or seek advice from another professional or fiduciary. Remember to always be a student of the game. Invest in yourself because your career and personal knowledge will be the engine of your wealth.
My Very Best,