Should I Own An Index Fund?
Should I Own An Index Fund?
The popularity of index fund investing soared during the last bull market. As of fall 2019, index funds surpassed actively managed funds in popularity for the first time. CNBC reported August 2019 that index funds totaled 4.27 trillion in assets compared to 4.25 trillion in actively managed funds.[1] Initially launched as a way for everyday investors to try and keep up with the market, index funds are popular today with some investors because of their very low fees and ease of purchase.
There is another reason index funds are gaining popularity and recognition: Efficient Market Hypothesis. According to this, it is difficult if not impossible to outperform an index, so why try? Advocates of the Efficient Market Hypothesis argue that active management of a portfolio is useless, so just buy an index and go for the ride.
We want you to be aware that Efficient Market Hypothesis has both advocates and detractors. There are many academic studies that argue against Efficient Market Hypothesis but that is beyond the scope of this blog.
The first index fund, the Vanguard 500 Index, debuted 45 years ago. Today, more than 3.7 million indexes exist. Though most don't have funds tracking them, it goes to show how flexible the idea of passive management has become.[2] For the sake of simplicity, this blog will focus on the S&P 500 Index funds.
Here are four things to consider if you are thinking about index investments:
1. Diversification
Diversification is a double-edged sword. Index funds offer broad diversification, and this can help avoid some human error in stock picking. Regardless of financial conditions, market health, or opinions about the economy the index owns it’s constituents. This is positive in the sense that an S&P 500 Index will own many solid, household names such as Apple, Microsoft, JP Morgan, and McDonalds. On the other hand, some companies in an index may be of poor financial health. For example, Enron was once a large position in the S&P 500. Enron went bankrupt in 2001 and the stock went to zero. An index does not make judgment calls on the health or worthiness of it’s holdings; it passively holds stocks.
2. Low Expenses
Low cost is usually a good thing, and most index funds offer minimal fees which vary by the sponsoring company. In pays to do your homework. Some of the most expensive index funds have an expense ratio of as high as 1.43%. On a $100,000 investment, this fee is $1,430 annually assuming zero growth. Meanwhile, one of the least expensive funds charges .09%, or $90 annually.[3] Remember, both these index funds are supposed to be holding the exact same assets!
A downside of low expenses? Remember Enron; no one is evaluating the health of the assets in your index fund.
3. Passive Investing
The long term results of the past are well documented and they conclude that over very long periods of time index funds have done well. Over the last 25 year period ending April 30, 2020 the S&P 500 has an annualized return of 9.25%. This performance came with a wild ride though.
Consider that the S&P 500 reached an all-time high of 1,552.87 on March 24, 2000. From there, the index shed 49% of its value.[4] After the market bottomed in 2002, a good run lasted until the financial crisis of 2008 brought a market decline of 54% in 2009. What is the long term impact on an index investor? For an investment made at the high in 2000, an investor may have seen small gains in 2007 but ultimately it took 13 years before the account was positive and stayed there.
4. Active Management (or lack thereof)
The debate over active and passive investment management can be heated. To stick to some basics facts, CNBC reported in March 2019 that for the ninth year in a row a majority of large cap funds trailed the S&P 500 in returns. After a 15 year period ending March 2019, 92% of large cap funds trailed the S&P 500.[5] On the one hand, that data is a vote in favor of index investing. On the other hand, one might consider looking more closely at the managers that have successfully outperformed the index.
Final Thoughts
In January 2019 I was at an investment conference and heard a man talking about disruption in corporate America. Disruption occurs when a new company “disrupts” the business and profitability of an older, more established company. A good example of disruption would be Blockbuster and Netflix. Blockbuster used to be a part of the S&P 500 Index and when Netflix gained popularity the video rental business dropped so much that, according to Wikipedia, “Blockbuster filed for Chapter 11 bankruptcy protection due to challenging losses, $900 million in debt, and strong competition from Netflix, Redbox and video on-demand services”. They were also eventually kicked out of the S&P 500 Index.
The speaker at my January 2019 conference said this: “The pace of disruption in America is accelerating at a rate most people don’t appreciate. In fact, I predict that, in the next 10 years, up to 35% of the companies in the S&P 500 Index will be disrupted. Whenever I hear of someone who owns an index fund I simply say, ‘Good luck with that.’”
Time will tell if this man is correct. Or as Yoda, the Jedi Master once said, “Hard to read the future is…”
Is an index fund the investment vehicle of the future or the past? If you would like to learn more about index funds, we’re here to help.
Important Disclosures
An index fund is a collection of stocks, bonds, or other securities that tracks a market index, a group of securities that's used to represent a segment of the market. Index funds are available for a wide range of investments including; stocks, bonds, commodities, and real estate investments. The primary objective of an index fund is to match the performance of the underlying index. Index funds have fund managers whose job it is to ensure that the fund tracks its underlying index. An outside third party index provider creates and maintains the index itself and the job of the fund manager is to buy the investments that the index provider puts in the index, and then make further purchases or sales when the index provider makes subsequent changes to the index. Index funds can be structured in two primary ways; index mutual funds offered directly through mutual fund companies or brokers who offer access to index mutual funds in their brokerage accounts and index exchange-traded funds that trade directly on stock exchanges, allowing anyone with a brokerage account to buy or sell shares at any point when the stock market is open for trading. Before investing, consider the investment objectives, risks, charges and expenses of the index fund and its investment options. Read the fund's prospectus for more detailed information about the fund. Contact the fund for a free prospectus and, if available, summary prospectus containing this information. Read it carefully.
The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. You cannot invest directly in this index. All indexes referenced are unmanaged. The volatility of indexes could be materially different from that of a client’s portfolio. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. There is no guarantee a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Past performance does not guarantee future results.
Securities offered through IFP Securities, LLC, d/b/a Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, d/b/a Independent Financial Partners(IFP), a Registered Investment Adviser. IFP and Callesen Wealth Management are not affiliated.
The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and it advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors.