Myth vs. fact: What people still get wrong about index funds
This year marks the 40th anniversary of one of the most important concepts in investing, yet it's safe to assume plenty of investors still don't understand it well.
The idea of buying and holding the same stocks found in market benchmarks — without trying to pick winners — is still a bit controversial. Critics call it an uninspired strategy that saddles investors with mediocre returns. Proponents point to actual results that are above-average. At any rate, indexing has gone mainstream, with hundreds of mutual funds and exchange-traded funds, up from zero before the Vanguard 500 Index, the first portfolio available to retail investors, debuted 40 years ago. Many pension funds also utilize the strategy.
Here are some myths and misconceptions about indexing.
All index funds are pretty much the same.
Myth. It's more accurate to say that index funds of a similar ilk — such as those tracking stocks in the Standard & Poor's 500 index — should perform more or less equally. But indexing has expanded to include other assets — bonds, foreign stocks, small companies and other investments — so the funds clearly aren't all alike.
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Even among rival funds that hold the same types of stocks, there can be subtle distinctions that result in dissimilar performance. Rival portfolio management companies charge varying expenses. They also might employ different tactics (such as the use of options) to invest.
There are many indexes. Most are capitalization-weighted, meaning the most valuable companies — giants like Apple, Microsoft and ExxonMobil — exert the greatest influence and receive the lion's share of investment dollars. Other indexes weight each stock equally.
Index investors must accept mediocre returns.
Myth. Because index funds feature lower expenses, they tend to beat the majority of non-indexed, actively managed rivals over time. Costs eat into returns, so funds that charge less enjoy a performance tailwind. In addition to higher costs, many active funds underperform because of portfolio blunders — moving into certain stocks or other assets at the wrong times.
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Indexing only works well with large stocks.
Myth. Indexing has mostly focused around large stocks such as the big companies in the S&P 500. But the approach also can succeed with bonds, foreign stocks and other assets, according to Vanguard. This isn't too surprising when you consider that trading costs frequently are higher in these other areas. Because index funds minimize trading, they incur lower costs.
"Probably the biggest change indexing has brought to investing is that it's opened everyone's eyes to the importance of costs," wrote Joe Brennan, head of Vanguard's equity-index group. "The bar has risen for (active) managers to produce investment performance in excess of the market return after fees — a feat that has proven difficult."
Small-stock value funds appear to not fair quite as well. Over the 15 years through Dec. 31, active small-value managers beat their indexes by nearly 0.8% a year on average, according to Vanguard.
Index funds struggle to recover from bear markets.
Myth. Index funds stay fully invested in stocks (or other assets), so it can be painful holding one during a broad, sustained retreat. The flip side is that index funds are ideal vehicles when markets start to recover. Because the funds stay fully invested, there are no timing decisions. Active fund managers who retreat to bonds or cash will face the dilemma of when to re-enter the stock market. It's not an easy call to make.
Index funds are ticking tax time bombs.
Myth. Large distributions are rare among index funds. If anything, index funds are highly tax efficient. They rarely pass taxable gains through to shareholders because they don't do much selling.
Reach Wiles at russ.wiles@arizonarepublic.com or 602-444-8616.