Can Index Funds Beat Financial Advice?

March 2, 2006 4:47 AM

Can a Portfolio of Index Funds perform as well as portfolio selected by a financial advisor (net of all fees), over the long-term?

I've been using a full-service broker (Morgan Stanley) for the last couple of years and I realize that was not a good decision. It had to do with emotional family stuff. The performance has been pretty average and the broker charges 1% of the portfolio value annually. This fee is on top of the internal expenses of mutual funds, of course.

I want a portfolio that doesn't have to to be watched constantly, has the lowest fees possible, and produces average returns, at the very least. The point being, if I can match the returns I'm getting now (around 8%, net all fees) and not pay all of the fees why not go with Vanguard funds, for example? It would be great to hear from those who have had experience on both sides of this investing fence.

posted by philmas to work & money (32 comments total)

Yes. Index funds normally do better than managed funds, especially when the cost of management is factored in. It's important to remember that most managers _don't_ "beat the market".
posted by Pseudoephedrine at 4:49 AM on March 2, 2006

Pseudoephedrine is correct; index funds beat the average managed fund once you factor in management costs.

There are, obviously, individual managed funds that do much better than index funds. If you are able to determine which funds will beat the indexes in advance, well, you've missed your calling and should be a filthy rich wall street trader.
posted by Justinian at 4:54 AM on March 2, 2006

If index funds perform better over the long term, what's the point of managed funds?
posted by ThePinkSuperhero at 4:57 AM on March 2, 2006 [1 favorite]

Making money for fund managers and fund management companies. Really.
posted by Justinian at 5:02 AM on March 2, 2006

If index funds perform better over the long term, what's the point of managed funds?

People are greedy and gullible, and like the idea of 'beating the market'. Of course, you never see adverts for the funds that didn't.

Philip Greenspun has a couple of pieces worth reading on the subject. He also references Burton Malkiel's A Random Walk Down Wall Street, one of the first books to argue that individual investors are better off sticking their money in index funds.
posted by holgate at 5:08 AM on March 2, 2006

It's a nasty generalisation to say "index funds perform better over the long term"... and as we know, all generalisations are wrong.

However, they quite often will. eg Years ago I worked at a broker (not a fund manager) who were very pleased with winning the BRW 'top broker' award based on their buy/sell/hold recommendations. They scored a whopping 48% right, and they were best in the country.

As to the point of managed funds - they provide some specialisation. Say I don't want to invest in sector X because I think it will be a dog over the next few years, an index fund may not allow me to avoid that sector.

The sad fact is that the thing managed funds have over indexed funds (at least in the market I work in) is marketing, and commissions to advisors. This is one of the reasons their fees will be higher, and the returns, net of fees, suffer for this.

[THIS IS NOT FINANCIAL ADVICE AND IF YOU FOLLOW MY RECOMMENDATIONS YOU WILL LOSE ALL YOUR MONEY]
posted by pompomtom at 5:11 AM on March 2, 2006

If you only read one book on this topic, make it Bernstein's Four Pillars. He goes over this and more and will help you build a good investment strategy for yourself that stays far from brokers and money managers and the like. In brief, a managed fund, since it's part of the market, is just as likely to fall short as outperform, and only when it's small. When it's large, it is the market, so all you end up getting is, at best, index returns less lots of fees. Personally, I use Vanguard as a good, low-cost and reputable place to invest.
posted by ny_scotsman at 5:23 AM on March 2, 2006

If index funds perform better over the long term, what's the point of managed funds?

Why do people continue to go to Vegas and Atlantic City when it has been statistically proven time and again that over the long term they will lose money? People like to gamble. No one ever brags about how their index fund was up 15% last year. They can only get 50-100% returns from managed money. It's not fun nor is it sexy being prudent and building wealth incrementally. Another big reason people give their money to others to manage is because if they lose - they'd rather blame someone else than themselves. Of course if they win they'll take the credit.
posted by any major dude at 6:23 AM on March 2, 2006

The plus side of managed funds is that some single-sector funds may provide better diversification than an index fund.

For example, I know of no index funds for Canadian energy companies, which is a pretty hot sector. For now. The same goes for geographic diversification - there's no Asian index fund, Latin American index find, etc.

But for broad funds, like a generic large-cap find, indexs do just as well.
posted by GuyZero at 6:41 AM on March 2, 2006

I want a portfolio that doesn't have to to be watched constantly, has the lowest fees possible, and produces average returns, at the very least.

You just described index funds, SPDRs and bonds. Now go forth and invest.
posted by frogan at 8:11 AM on March 2, 2006

Even people who make a living out of investing money agree that index funds are best for consumers. David Swensen, CIO of Yale University (and a damn good investor) wrote a book recently that trashed managed funds thoroughly. Between 12b-1 fees (charging shareholders for the privilege of owning a fund that gets advertised on TV during "Meet the Press"), deceptive practices like market timing, and more accounting problems then you want to know about, you are best leaving all that behind.

Also, not all index funds are the same. Go not just for an index fund, but an index fund run by a non-profit company, like Vanguard.
posted by profwhat at 8:12 AM on March 2, 2006

Index Fund Advisors is a very nice website done by a financial planning firm that is fee only and helps individuals such as yourself, set up portfolios of index funds. (Note: I have not used them myself, but the literature on their website is very well done)

I will have to respectfully disagree with pompomtom above. Some generalizations are true. For instance: Over a long window (5+ years), index funds on average beat managed portfolios. The last time I was looking into this area seriously I could not find one example of a managed mutual fund that had beat the market over a 10year period. Not one, anywhere. So yes, over 1 year, or 2 years you will find funds above average. However, the problem is that the fund that beat the market this year, is not likely to beat the market next year. So over the long term you are better off with index funds.

Also to follow profwhat's statement. One of the biggest factors in picking a good index fund is finding the one with the lowest fees. As mentioned, Vanguard funds usually have very low fees. The lower the fees, the more closely you can come to matching the market average.
posted by bove at 8:20 AM on March 2, 2006

And you can still beat the market as a whole with index funds. I own mostly index funds, but I own various sector index funds at different times. I bought the Vanguard (mentioned above) REIT index fund (basically an index of real estate investment trusts) a few years ago and it did very, very well. You don't need to only own an S&P index.
posted by Justinian at 8:23 AM on March 2, 2006

If index funds perform better over the long term, what's the point of managed funds?

Diversification. Over the course of time, index funds should outperform a given managed fund. That's the whole point. Investing straight index funds will give you the market performance over that time. If you think you have some information not everyone else has, maybe you take a shot at a specific sector short-term.

Which is not very different from why people go to Vegas, I suppose. The "Not me" school of thinking.
posted by yerfatma at 9:32 AM on March 2, 2006

There's a review of David Swensen's at NPR.
posted by AlexanderBanning at 9:39 AM on March 2, 2006

Sorry about that... There's a review of David Swensen's *book* at NPR. profwhat mentioned this book in his/her comments above.
posted by AlexanderBanning at 9:43 AM on March 2, 2006

Um, the reason you pay a broker is because a broker has enormous amounts of education, expertise, time, and support personnel that your average investor doesn't have. The broker can make better investment decisions than you can. Also a broker can provide additional services that are important for managing a large amount of money.

Also note that you are playing the averages game. Index funds are reliable but their returns are generally pretty small. There's little risk and thus not much reward either.

The last time I was looking into this area seriously I could not find one example of a managed mutual fund that had beat the market over a 10year period.

I don't know where on earth you got this. You must be looking at the many relatively small, public mutual funds that are offered on the board.

Diversification.

Not really. Diversification is a tool to reduce risk. It also tends to reduce reward. Investing in one company or one sector that grows several hundred percent will always provide far more return than any index fund.

If you're just looking for a glorified savings account and you're not investing that much money then yes, index funds are definitely a good way to go. If you're looking to double your money sooner rather than later than index funds won't get you there.
posted by nixerman at 9:45 AM on March 2, 2006

Frankly, most people looking to "double their money" sooner rather than later end up halving it instead. Investing isn't about trying to double your money insanely fast, it's about growing your principal at a rate which balances risk and reward.
posted by Justinian at 9:50 AM on March 2, 2006

Frankly, most people looking to "double their money" sooner rather than later end up halving it instead.

Uh, yeah. Did you just do a survey?

Anyways, many people do indeed look to double their money every 5 years or so. This is indeed possible and not unheard of, but it requires accepting a certain level of risk. Again, if you're looking for minimal risk and maitenance, index funds are a good choice but they only bring moderate returns. Brokers exist for the same reasons corporate management exists: the free market is really not that efficient and to get the best bang for your book, some sort of active managing force (that's all the rich guys on Wall St.) is needed to manage resources.
posted by nixerman at 9:59 AM on March 2, 2006

If index funds perform better over the long term, what's the point of managed funds?

To employ fund managers?

It's a question The Fool and many others have addressed. My personal conclusion is "there isn't one," at least for me. My retirement and profit sharing money is split between the Vanguard total stock market index fund and the total international.

A number of folk contend there's no evidence that over the long term (which your retirement savings, if nothing else, should be exclusively concerned with) no manager has ever out-performed the DOW.
posted by phearlez at 11:57 AM on March 2, 2006

Nixerman, doubling every 5 years is about a 15% return per year. An S&P index fund, about as bog-standard an index fund as you can get, returned more than that over the last 25 years.

It's absolutely true that you won't beat the market by buying a market index fund. That's tautological. But you're ignoring the fact that most people who buy actively managed funds do WORSE than the market. Avoiding index funds, on the average, means you do worse than the market. Yes, some people do a lot better. But most people don't. It's a statistical fact.
posted by Justinian at 12:02 PM on March 2, 2006

It sounds like you're looking for a couch potato portfolio, which is basically creating a target asset allocation using index funds as the building blocks. The idea is that your chances of getting a good return are maximized if you: 1) Minimize fees and 2) Stay diversified.

More info on this idea is here.

Personally, I think the concept has a lot going for it. It's easy, requires a minimum of effort on the part of the individual investor, and is highly likely to beat the vast majority of actively-managed funds over the long term.
posted by gwenzel at 12:07 PM on March 2, 2006

URG - URL didn't work right. Let's try this again:

Couch potato portfolio.
posted by gwenzel at 12:09 PM on March 2, 2006

doubling every 5 years is about a 15% return per year. An S&P index fund, about as bog-standard an index fund as you can get, returned more than that over the last 25 years.

The S&P 500 has returned 9.54% per year over over the last 25 years (on March 2, 1981 it closed at 132.01, today it is 1,288.81). Between 1926 and 2001, it returned 10.7% per year (Ibbotson).
posted by milkrate at 12:57 PM on March 2, 2006

You are correct, milkrate: I looked at the closing figures for the S&P, saw that it had gone up 160% or 180% in a given decade... and promptly forgot all about basic math by dividing those figures by 10 (years in a decade) to get the annualized return. Of course it Doesnt Work That Way.

Thats why I buy index funds.
posted by Justinian at 1:32 PM on March 2, 2006

nixerman, if a broker can use his education and experience to get better returns, he'd use them to get better returns for himself rather than nickel-and-diming his clients to death. Although it's possible that you can get in early to a boom sector and make a few bucks, you have to look at your whole portfolio and account for losses as well as the wins. In the long term, you're going to have to be awfully lucky to consistently predict the market.

Asset allocation will allow you to play your hunches to some degree - rebalancing will keep you sane whilst everyone else is heading for the precipice.
posted by ny_scotsman at 1:48 PM on March 2, 2006

The S&P 500 has returned 9.54% per year over over the last 25 years (on March 2, 1981 it closed at 132.01, today it is 1,288.81).

You're forgetting reinvesting dividends, which would bump it up to between 10.5 and 12 percent.

It's possible for a managed fund to beat an index fund, just as it's possible to make money by placing 10% of your assets on ten bets on red at a casino. But in both cases the odds are against you.

If you think you have the knowledge and foresight to accurately predict that "Canadian energy" will outperform the market as a whole (or outperform the diversified portfolio of index funds you choose for yourself), then you're still wasting money by choosing a managed fund; if you have any substantial sum of money, just pick the stocks yourself, and you avoid squirrelly tax consequences, management fees, and the regulatory compliance costs of those prospectuses they have to send you every quarter that you aren't going to have time to read anyway.

My favorite financial columnist was Arne Alsin. He opened up his own managed fund. I stayed away from it because the management fees looked too high, and, sure enough, it's been underperforming the S&P by about the amount of the management fees. The really smart investment advisors are running hedge funds that you can't afford, not managed funds that are advertised on tv.
posted by commander_cool at 2:17 PM on March 2, 2006

To follow up on the couch potato portfolio: In case you're investing primarily for retirement, Vanguard and Fidelity both offer funds where you choose one of their target retirement dates and they shift the asset allocation over time from aggressive when you're young to more conservative when you're nearing retirement. They're funds-of-funds, so your fund invests in some other funds. For example:

Vanguard Target Retirement 2035

Fidelity Freedom Fund 2035

Vanguard's definitely has all index funds under the hood. Not sure about Fidelity. And other mutual fund companies are probably doing the same thing.
posted by expialidocious at 3:02 PM on March 2, 2006

As other people have said, indices do pretty well compared to mutual funds or actively managed accounts as a group. By employing an advisor, you're paying for the opportunity to differ (up or down) from the market. Unfortunately, finding evidence of skill in advisors / investors is difficult enough, let alone identifying advisors likely to beat the market in the future.


Diversification is a tool to reduce risk. It also tends to reduce reward

Sometimes diversification reduces risk and increases reward. For example, adding 10% stocks to an all-bond portfolio often does so. Portfolio optimizers try to find the portfolio that maximizes return for a given level of risk. This portfolio lies at the efficient frontier.


For example, I know of no index funds for Canadian energy companies, which is a pretty hot sector. For now. The same goes for geographic diversification - there's no Asian index fund, Latin American index find, etc.

There are (index) ETFs that attempt to replicate the performance of these sectors. XEG.TO is a Canadian energy index ETF.
posted by blue grama at 6:31 PM on March 2, 2006

The plus side of managed funds is that some single-sector funds may provide better diversification than an index fund.

I'm at a loss as to how a single sector is more diversified than a fund that tracks a broad market index. Isn't that just the opposite of diversification?

For example, I know of no index funds for Canadian energy companies, which is a pretty hot sector.

If your goal is to focus on "hot sectors", you're not the kind of investor that is going to invest in index funds. Index funds are for those of us who want our money to grow at a reasonable rate, with a modest amount of risk, and a bare-minimum PITA factor.

The same goes for geographic diversification - there's no Asian index fund, Latin American index find, etc.

There are several index funds that track the MSCI EAFE (Europe, Australasia, and Far East) index, so it is possible to get some degree of geographic diversification from index funds.
posted by gwenzel at 6:01 AM on March 3, 2006

I'm at a loss as to how a single sector is more diversified than a fund that tracks a broad market index. Isn't that just the opposite of diversification?

I have a tendancy to make things sound like the exact opposite of what I mean. It's a rare skill.

What I mean is that if you wanted to diversify your personal portfolio, you might make some sector-specific investments outside of QQQ or some broad-based index fund. So you'd get some energy exposure, some real estate exposure, etc. I didn;t mean to suggest putting all your money in a single sector fund.

As for investing in "hot sectors", I'm a pretty passive investor but I would like a bit more exposure to some high-growth sectors. But picking energy stocks in Canada is pretty risky business, so a energy-based mutual fund or index fund offers (to me) a good combination of higher growth without a lot of extra risk.

Just like a "real investor" would make picks in a number of industries/sectors/geographies, lazy investors can do the same by picking a few different mutual/index funds.

blue grama, I wasn't aware of XEG.TO, so thanks.
posted by GuyZero at 12:52 PM on March 3, 2006

On the topic of sorts, Warren Buffett has some choice words to say about funds, fees and managers.
posted by phearlez at 2:31 PM on March 8, 2006