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  • Writer's pictureHugh F. Wynn

Index Funds Rule the Roost (IMHO)

Quality is often in the eyes of the beholder. Webster’s dictionary has a whole slew of definitions, most of whom simply cloud the issue. I like a simple little internet definition: the standard of something as measured against other things of a similar kind.

When it comes time for selecting an investment vehicle, help is so plentiful as to be confusing. When seeking information about a mutual fund – managed or Index – I always like to know what Morningstar (they specialize in mutual fund investing) thinks of a given fund. But my favorite information source is Vanguard’s trove of their own funds’ histories and investment guidance (yeah, I’m biased), particularly the “pitfalls that investors should avoid.”

Performance Chasing

Being human, we’re all vulnerable to the lure of past performance (stocks, funds, racehorses, whatever). And though many of us have learned important lessons in doing so, it’s an oft repeated mistake. Generally speaking, investing based “strictly” on past performance is a quick ticket to mediocre results or failure. Keep in mind that superior past performance might be based on excessive risk-taking, luck, or other factors having nothing to do with quality. Of course, superior performance can also be based on good management, but be cautious, managers come, and managers go.

Paying Too Much

A mutual fund investment is accompanied with management fees – a lot in some cases, very little in others (index funds fall in the latter category). Vanguard research has found that less expensive funds, even actively managed funds, have a better chance of beating their benchmarks than more expensive funds. The reason is obvious. Lower fees simply allow investors to keep a greater portion of the fund’s return. Pay for good performance, but don’t pay too much! You don’t have to. Do your homework. The information is out there, much of it free for the taking.

Adopt Reasonable Expectations

If you’re like me, you don’t like losses. The simple fact is, no matter how good fund managers are, they will underperform the market from time to time (usually quite often). Vanguard reported that of the 2,202 “active” equity funds that existed in 2001, only 476 outperformed the market. And 98% of that 476 group underperformed the market in at least 4 out of the 15 years ending December 31, 2015. Vanguard’s analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of the period.

This Vanguard-provided history is a bit dated, but it reinforces several of my PDQ Principles of Investing. And more recent studies support the data. Be patient. Don’t abandon a fund during a downturn or setback. Have reasonable expectations about the fund’s performance, whether managed or unmanaged. Diversify. And give index funds a hard look versus managed funds. In short, dare to be average.

Index Funds Now Rule The Roost

If you decide to invest in a broad market index fund, you’ve bought quality. According to S&P Global, more than 80% of U.S. actively managed equity funds underperformed the S&P Composite 1500 in the decade ended 2018 – or no longer exist. Small wonder that droves of investors have abandoned active funds in favor of passive index funds, and the trend continues. In fact, today’s Wall Street Journal carried this news. “Funds that track broad U.S. equity indexes hit $4.27 trillion in assets as of August 31, 2019. Funds that try to beat the market had $4.25 trillion as of the same date.” This is a major investment event and another recognition that it’s hard to beat the market.

So, Why Not Dare to be Average?

As I summarized in my book, The Generation-X Files (Dare to be Average), even if you decide not to go the index fund route, any investment technique worth its salt should do several things, including: provide a competitive rate of return over time relative to other available investment opportunities; offer reasonable diversification among stock, bonds and cash; be tax-friendly when not under the umbrella of a tax-deferred retirement plan; have a low maintenance cost (whether it be an annual expense ratio or an advisory fee); and require minimal oversight (to avoid those sleepless nights). Index funds offer these characteristics, but who am I to judge what’s best for you? Check it out for yourself!

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