Index Funds Are Not a Silver Bullet

I recently finished the book Trillions, and I would recommend it to anyone who enjoys reading about the history of finance.

The story boils down to how passive investing slowly and then suddenly took over the (investing) world. While Vanguard remains synonymous with the index fund, other companies such as State Street, Blackrock, Fidelity, and many others have contributed to making index investing into the juggernaut it is today. Its growth has even eclipsed expectations. Allan Sloan reported in Yahoo Finance in May that retail investors’ dollars in passive investments have officially overtaken actively managed funds.

There is no question that index funds are a powerful tool for investors, but are they the only option every investor needs? I think the evidence would dispute that. Despite what you read from every casual finance influencer (here, here, here, here, here…need I go on?), there is more to investing than just buying VOO and planning your next vacation. If you only think about expense ratios then you are stopping short of fully understanding how to choose investments.

I have no beef with index funds and use them myself, but it is essential to understand that they are only one tool amongst many and have their own advantages and disadvantages. They do outperform at times, and they also underperform at times. Are they faster and easier to understand than active management? Most time yes, and that is one of the biggest reasons for their popularity.

The real question is:

Are they better than actively managed funds? No.

Are they worse than actively managed funds? Also no.

If that is confusing, then read on. Unfortunately, it's just not that black and white. This focus on better vs worse and cheap vs expensive is a mirage. There is much more nuance to choosing an investment vehicle and in the remainder of this piece, I’d like to discuss some of the least understood differences.

Performance and Fees

First let's consider the question underlying all the discussion about expense ratios: performance. Do index funds always perform better than active funds? The answer is no, they don’t outperform all of them, but they do outperform many of them. The question is, which active funds show signs of life and can they be spotted? Here are a few clues:

1. Mutual fund size: It is a myth that mutual fund size creates a meaningful lag on performance. Mutual funds are under no obligation to accept your money when it risks their goal of excellent market returns. Many will close their doors at times to maintain performance when necessary. Size demonstrates success and also creates access. Access to IPOs, information, resources, preferred investment terms, and execution. Size also creates economies of scale. It is no secret that larger funds can charge less than a fund of comparable strategy but limited size. Aha! So costs do matter! Yes, but only a little. If Active Fund A can execute a strategy for 50% less than Active Fund B, then it's likely Active Fund A will post better returns. Where do index funds fit in? They don’t. They aren’t executing any strategy and could be considered the biggest funds of all. They are following an index, not an investment thesis so the comparison doesn’t fit.

2. Manager Tenure: Are you good at your job? If so, your employer is apt to keep you. It's easy to measure good managers since they are the ones who are performing well and growing their funds. Manager tenure has a positive correlation with outperformance. If you aren’t performing well and aren’t growing your fund, you just don’t last.

3. Mandate: The purpose and constraints of a given fund can impact performance. Active management can to outshine index funds due to adaptability, risk management, and hedging. An active fund that is mandated to be closely tied to a benchmark will have a much harder time beating it than one that has free reign to execute a unique strategy. If Active Fund A is targeting Large Cap US stocks and holds 450 companies, it is going to struggle to beat the S&P 500 since it is almost a mirror of the index itself. An active fund that holds 75 companies across many market capitalizations has a greater opportunity to outperform with a talented management team.

Not all actively managed funds are created equal. Some are vastly better than others and finding better managed, better researched, and better executed funds mean the difference between outperformance and underperformance. When people toss out the statistics that index funds beat X% of actively managed funds, they fail to take into account how terrible the lowest tier of active funds really is. Differentiating between good, decent, and outright terrible, changes that comparison quite significantly.

If you were choosing a sushi spot, would you opt for the one with critical and commercial success or just choose the most convenient option close to your house regardless of the quality? That gas station wouldn’t be selling sushi if it was bad, right? Right?

Next, let's talk about fees. It irks me when I see advertising like this chart from Vanguard:

What this chart is saying is that you pay more fees to an active mutual fund manager than you do to Vanguard using their index funds. The expense ratio of the active manager (0.49%) vs the Vanguard index fund (0.09%) creates a large difference in fees paid as shown above. However, this difference in fees has absolutely no bearing on the return the hypothetical investor would receive.

The assumed growth is 6% as shown by Vanguard. Fees in and of themselves do not impact prospective returns. In fact, returns as reported by all mutual funds are net of fees. Therefore, in their example, our hypothetical investor would receive the exact same return in both investments.

Now, you might say: “But wait, the active fund must create an extra 0.4% excess return to yield the same net return as the index fund.” That is true! It does, and that is what you would be paying for. If you don’t believe the manager can outperform, you shouldn’t be investing in that fund. Could you be wrong? Of course, but opportunity cost is the price of admission no matter where you put your money.

Lastly, the price you pay for an actively managed fund should have some reason behind it. You don’t want to pay active management prices for only passive management benefits. Active management should reduce correlation risk, access hard-to-reach markets, and offer nimble or unique investing strategies to name a few.

Market Efficiency

I am neither smart enough nor daring enough to challenge the multiple Nobel Prize-winning economists who have tackled The Efficient Market Hypothesis. What I will say is that some markets are more efficient than others. Lack of efficiency favors active management.

Opaque, closed-off markets require a careful and selective hand to guide an investment strategy rather than a simple capitalization-weighted approach. Foreign stock and bond markets are notoriously challenging*. Oftentimes, even niche domestic markets can have enough slack to allow easier outperformance for a veteran portfolio manager.

Let's zero in on US Short-Term Bonds as an example. Out of 214 funds listed in Fidelity’s Mutual Fund Comparison Tool, only four are index funds. The top of the heap for index funds is VSCSX (Vanguard Short-Term Corporate Bond Index Fund Admiral Shares) with a 10-year average return of 1.73% and an affordable 0.07% expense ratio.

How does VSCSX stack up? Unfortunately, it is 19th behind 18 actively managed funds. Net of fees, many of these actively managed funds have nearly double the average return of the Vanguard fund while having 5-10x the expense ratio (and remember this is all net of fees).

This isn’t a fluke either, we can do the same for small-cap US equities.

PSSIX (Principal SmallCap S&P 600 Index Fund Institutional Class)

• 11.23% 10 yr average return

• 0.21% expense ratio

• 109th behind 108 actively managed funds

Private Markets

Index funds by their nature limit themselves to only the public markets and the market indexes they track. This can be a big disadvantage for retail investors who often miss out on the growth of private and public companies prior to index inclusion.

Private companies are never included in indexes but are one of the largest growth areas in our economy. Look at the chart below which shows the growth of four major public companies. What do they all share? Enormous growth pre-IPO, and more muted growth post-IPO.

In the public markets, take the recent example of TSLA which was added to the S&P 500 on December 21, 2020. As reported by Research Affiliates, “on the day Telsa entered the S&P 500 it was the sixth largest US company by market capitalization. Tesla was the largest addition to the S&P 500, both by market capitalization and rank, in the index’s history.”

The size of TSLA at the inclusion was indicative of the returns it has garnered up until that point. In the year prior to the inclusion, investors raked in +1,014%. However, the return investors received in the year following the inclusion was a paltry +38%. Investors who only invest in index funds are often unable to take advantage of fast-growing stocks that simply haven’t met inclusion criteria yet.

Asset Location

Where you hold a given fund is just as important to factor in as what you invested your money in in the first place. If your assets are in a tax-deferred account like an IRA or a 401(k) index funds’ superior tax efficiency doesn’t matter. However, in a taxable brokerage account, it could matter. Remember it isn’t what you make, it’s what you keep.

How will you know whether it should matter to you?

That all comes down to your marginal tax bracket. For 2022, if you make less than $41,675 as a single filer or $83,350 as a joint filer, then you will have a 0% capital gains tax rate. This applies to the majority of households in the US. Tax efficiency just doesn’t matter for these investors and it is one less thing to consider when making your investment decisions.

Final Words

So is it all just marketing from “Big Index”?

In the end, the answer is both yes and no. Expense ratios in the extreme, do separate winners from losers in the mutual fund space, but for 99% of investors and the funds where they place their money, it is far less important than you’d think if you survive solely on a diet of internet coaches and Bogleheads blogs.

Up to a certain point, an investor’s savings rate is the biggest factor in their investment growth. If you have $10,000 saved, the difference between a 9.5% and a 10% return is $50. That is equal to $4.16/mo. If the only difference between the two investments is a 0.5% expense ratio, then yes, you might be able to close that gap by minimizing expenses. You could also save $50 more per year (or both). You’re better off focusing on saving at the early stages of your investing journey than you are optimizing your expense ratios.

All investors can benefit from successful and proven actively managed funds. To do so, you may have to actively research. Active management has many advantages over index funds and vice versa. How and when you apply those advantages is what will improve your return. If you aren’t willing to do that, index funds can be the next best option.

For many investors, index funds are quick and easy options that are easier to understand. That might be reason enough to choose them, but it is a far cry from making them a superior investment vehicle. Investing in something is better than investing in nothing but choosing the right ones for your goals will make you more likely to be successful.

*Take the time to read Red Notice by Bill Browder. Not only is this an excellent book about investing in an emerging economy, it is also an excellent book about the politics and risks in Russia during the 1990s & 2000s.