Tag Archives: index funds

CNBC Says It Might Be Time for Index Funds

With just one in four fund managers beating their benchmarks this year, CNBC.com says it might be time for investors to ditch actively-managed mutual funds and just buy index funds. While CNBC didn’t say buy ETFs, anyone worth their salt knows the cheapest, most tax-efficient, most flexible index funds come in the form of ETFs.

CNBC.com reports that “only 23% of large-cap managers beat the S&P 500 and 27% outdid the Russell 1000, according to Bank of America Merrill Lynch.” While the fund managers interviewed for the piece make it seem like this was an unusual year, the actual numbers aren’t that shocking. Scads of research show that the indexes annually beat 70% to 80% of all active funds.

Since 2008, many investors have been wondering what they are getting for the high fees they pay to active mutual fund managers, especially in a down market. While it may be difficult to beat the index on the upside, if active managers can’t protect your assets on the downside, what’s the point of going active?

And it doesn’t look like things are getting better anytime soon. Philippe Gijsels, the head of research at BNP Paribas Fortis, thinks that not only won’t we see a Santa Claus rally, but in fact, the September/October rally was just a respite from an end-of-year decline and long-term move to the downside. Gijsels says the longer the European Central Bank fails to find a solution the worse it will get for the equity markets here and abroad. If this French banker doesn’t believe a solution is near, it’s time to worry.

In another corner of Bank of America Merrill Lynch, technical research analyst Mary Ann Bartels says the sell-off will continue and may not hit a bottom until the first quarter of 2012. She predicts the S&P 500 could test the October low of 1074, a 14% drop from today’s close of 1244.

Schwab Ready to Enter ETF Market

Mutual fund giant Charles Schwab Investment Management expects to launch its first ETFs during the first week of Novemeber.

A subsidiary of The Charles Schwab Corp., the investment management unit is one of the nation’s largest asset management companies. It held more than $210 billion in assets under management as of September 30. The firm, which says it’s the third-largest provider of retail index funds, manages a total of 82 mutual funds, with 36 actively-managed.

Making the Case for Index Funds

Investing is long term. Speculation is short term.

Can you watch the market every day? If not, you should invest, rather than speculate. Without a doubt indexing is the way to invest. The crash of 2008 has not only highlighted the risk of owning single stocks, but also exposed the dirty underbelly of actively managed mutual funds.

Going for the index avoids getting stuck with the stocks that might be left behind. If you believe in the concept of diversification, then single stock risk is just too huge of a risk to take. And while you might be able to buy 20 stocks and build out a nice portfolio, one bad stock can wipe out 5% of your portfolio and two bad stocks decimate the fund. (Get it? Decimate? Remove 10%. Ok, moving on. …)

If you want to own financials, 30 are better than two stocks. If the two financials you owned last year were Bear Stearns and Lehman Brothers, you, my friend, have completely lost your portfolio of financials, and maybe your entire portfolio. Buying an index fund tracking the financial sector of the S&P 500, such as the Financial Select Sector SPDR (XLF), gives you 80 stocks, about 11% of the S&P 500. You can get more exposure to one narrow niche of the market and diversification at the same time, hence less risky. Sure, the financials took a hit, but considering most of them are still in business, you still have some of your investment.

So, single stock risk is out if you’re not buying for dividends. But what about actively managed mutual funds? The whole point of the actively managed fund is to give you, the investor, alpha, those extra percentage points of return that comes from the fund manager’s skill and intellect. The financial crisis has shown how hard it is to find true alpha.

It’s pretty much common knowledge these days that only about 20% of active fund managers beat the major market benchmarks. Considering many active funds are essentially index fund copycats, you will never beat the market with their huge management fees. Fund managers counter that even if they don’t beat the market going up, they at least have the ability to post narrower losses on the way down, because they can sell off the worst performing sectors while the index can’t. I think a little bit of research will show they are also posting returns worse that the indexes on the loss side as well.

And even those that don’t post worse losses, is a 35% loss that much of an improvement over a 37% loss?

So, if you eliminate single stock purchases and actively managed funds, deductive reasoning says you must go with the index. Of course, this mostly applies to U.S. equities. In some markets, such as emerging markets, a smart manager might have some market knowledge that hasn’t disseminated widely, but in the U.S. that kind of information gets spread around pretty quickly.

Indexes can be volatile and risky. If the stock market falls, an index tracking the stock market will fall. However, with the index fund you can rest in the knowledge you matched the market and didn’t do worse than most of the market.

If you really want a lesson, John Bogle, the inventor of the index mutual fund, explains why indexing is better than stock picking in “The Little Book of Common Sense Investing.” Essentially, Bogle says you can maximize returns and lower risk by not buying single stocks but mutual funds. Followers of Bogle have written a book called “BogleHeads” which expands on this theme.

Now in a shameless plug for myself, my book ETFs for the Long Run takes Bogle’s argument one step further. I agree with Bogle that indexing is the way to invest. Bogle likes the mutual fund structure, but I think Exchange Traded Funds are the mutual fund for the 21st century. In the book, I explain indexing, the advantages of buying mutual funds instead of single stocks and then why ETFs are better than mutual funds. The key reasons being they are cheaper, more tax efficient, more transparent and more flexible. I also explain how to buy and sell ETFs and how to use them to build a portfolio.

Since you don’t know what sector of the market will rise, you should own a broad market index, such as the Vanguard 500 mutual fund, (VFINX), or buy an ETF such as the SPDR, (SPY), or the iShares S&P 500 Index (IVV). The Diamonds Trust (DIA) tracks the Dow Jones Industrial Average and the PowerShares QQQ (QQQQ) follows the technology heavy Nasdaq 100 index. The Vanguard Total Bond Market (BND) is a broad bond index.

Then you break it down into sector specific indexes that you want to follow.

Finally, you need to watch fees. ETFs typically charge smaller expense ratios than mutual funds. However, if you are dollar cost averaging, which in this market is the only way to go, the ETF’s commission will significantly eat into your returns if you invest less than $1,000 a pop. If you are investing less than $1,000 a pop, then go with a no-load index fund. Buying an index fund with a load is like paying for your own security in a gated community. It’s a waste of money.