The appeal of Indexing
The fund industry scoffed when Vanguard introduced its first index offering more than 20 years ago. One observer at the time said that because indexing meant "settling for average," it was therefore un-American. The corporate culture at Vanguard probably doesn't encourage gloating, but the company is certainly entitled to the last laugh. Its Index 500 fund currently sports a 5-star rating for the first time ever, and the fund is the industry's fastest-growing offering. It took in more than $7 billion last year, while top dog Fidelity Magellan suffered net outflows of nearly $6 billion. Fidelity subsequently lowered the fees on its own index portfolios and has promised to roll out more index offerings. All together, more than $117 billion is now invested in indexed mutual fund portfolios.
However, with all the buzz about indexing, there appears to be some confusion about what it actually is, accompanied by some unrealistic expectations. To their credit, the folks at Vanguard have taken great care to deflate these expectations (we've borrowed a few examples from their web site), but some investors are still setting themselves up for a big disappointment. Let's take a look:
Indexing, sometimes called passive investing, is simply buying an entire market basket of securities (or a portion of it) and holding it. No attempt is made to trade specific securities to boost performance. What's the advantage of this method? Some investors say that efficient markets ensure the triumph of indexing, but as Vanguard founder Jack Bogle laid it out 40 years ago, the strength of indexing stems primarily from its inherent cost advantage. Think of it this way: As a group, investors are the market, so their average investment return must therefore be that of the market. Hence, by investing in the entire market (or a close approximation of it) you will receive the same return as the average investor.
Big deal--who wants to be average? Well, in the real world, the average flesh-and-blood investor doesn't receive the return of the market--she receives the market return minus investment expenses.
It costs money to invest; there are brokerage and trading expenses as well as the fees that money managers receive. The average domestic-equity fund has an annual expense ratio of 1.4%. You can buy and hold an entire market or benchmark (via a low-cost index fund) for considerably less. By doing so, your after-expense return is bound to be higher than that of the average investor in that market:
Even Jack Bogle is wary right now, saying, "The impressive relative performance of the Standard & Poor's 500 Index over the past two years will not soon--if ever--return. It is a historical artifact that will soon be viewed as exactly that." Although chasing the return of the S&P 500 probably isn't as risky as putting all of your money in emerging markets funds at the end of 1993, it is based on the same dubious investment premise that the trend is always your friend.
On the other hand, the potential overvaluation of the S&P 500, and by extension, the index funds that track it, is not an argument against the philosophy of indexing. Some recent articles in the financial press have slammed "indexing" in its entirety by pointing out that the S&P looks scarily high and doesn't provide adequate diversification for many investors. That may be true, but it's a specious line of reasoning. Indexing fans aren't limited to the S&P. You can index just about any investment; large-cap stocks, small-cap stocks, real estate, bonds, and international stocks.
If you buy into the philosophy of indexing, forget about hopping on any bandwagons. After all, indexing means owning the markets instead of taking your chances with money managers who bet on the securities they pick. If you opt to index, it seems illogical to load up on a specific portion of the market just because it currently has a hot record. Granted, the S&P 500 represents nearly 70% of the domestic stock market, so it makes sense for most investors to have exposure to it. However, given its current valuations, now is certainly not the time to go overboard. If you're just starting out, or if you already own an S&P 500 fund, it makes sense to check out other index offerings, many of which benchmark less-inflated markets.