Is an index fund really a pot of gold at the end of the rainbow?

June 18, 2008 7:34 AM

InvestingFilter: Is there anything inherently flawed about investing in index funds?

I recently opened up a Roth IRA, and have invested in an S&P 500 Index Fund. I'll also be investing in a bond index soon.

I've been reading articles online and books such as 'The Lazy Person's Guide To Investing' by Paul Farrell. These books make it seem that investing in anything but index funds sets you up for a loss long term.

In my opinion, I'm a passive investor. I don't have the inclination to try and pick hot stocks. I'm fine getting a market average return. Farrell's book and some other sources such David Swenson make it seem that investing in anything but an index fund is lunacy. They harp on about load funds and how actively managed funds always underperform the market.

My question is: What's the catch about investing in index funds? It seems to good to be true. You keep putting money in and 30 years later, a nice pile is waiting for your retirement.

Some input from the more financial minded members of the Hive Mind would be much appreciated.

posted by reenum to work & money (24 comments total)

Well, by definition, you're not taking as much of a risk as you might be. And you are far from guaranteed to have a nice pile waiting at your retirement - the whole market may well crash.

But there really is no 'catch' if you're risk-averse. The catch is, you don't have a manager picking stocks and maybe beating the market so much that you become massively wealthy. Nor are you trying to carefully time AAPL and GOOG purchases and sales to make MILLIONS. You will not get rich with index funds.

But if you accept their basic premise and are perfectly happy with market average returns, there really isn't much of a catch.
posted by Tomorrowful at 7:42 AM on June 18

There are a number of "catches," none of them particularly compelling. Let's lay some of them out.

1) You may be investing in things you don't want, companies that are guaranteed to do poorly. For example, there are a lot of banks in the S+P 500. Banks have been doing poorly lately. Over the last year the underperformance in bank stocks has pretty much counterbalanced the rest of the index's gains. It is sort of frustrating to sit there and look at your index and think "I wish I didn't buy all that bank stock."

2) You may be investing in things that are socially irresponsible, like Alliant Techsystems who make all the bullets that are killing people in Iraq, or Altria Group who make a lot of cigarettes that cause heart attacks, strokes and cancer.

3) There is no guarantee that the index you're choosing will outperform the risk-free rate, which is generally thought of as equivalent to the rate on long U.S. Treasury bonds. You can even lose money in the stock market. In that case, you keep putting money in, and a diminished amount of money is available for your retirement. Most folks don't believe this would happen but there is certainly no law or rule preventing it.

4) ... PROFIT!

Like I said, not very compelling. Index funds offer a lot of benefits.
posted by ikkyu2 at 7:52 AM on June 18

Warren Buffett recently bet $1M that over 10 years, the fees from a load will outweigh any gains from an actively managed fund, and thus that an index fund will outperform an actively managed.

And I think he knows a bit about investing.
posted by Lemurrhea at 7:52 AM on June 18 [1 favorite]

Due to the recent popularity of index funds, several fund companies are charging higher fees than necessary. If you're considering an index fund, always remember to compare its expense ratio against other similar index funds. The expense ratio is typically around 0.25% for comparison purposes.
posted by netbros at 7:52 AM on June 18

Nothing Tomorrowful said is wrong, but in my perspective the tone of his comment implies that Index Funds, are overly safe. However, I think they are the right choice for virtually any investor. Let me tell you why. There are a number of economists who believe in the Efficient Market Hypothesis. What this means is that the stock market is perfectly efficient and therefore it is only possible to beat it by chance, and beating it long-term is highly unlikely.

Most investors believe that the market is not perfectly efficient. Therefore, it seems like you would have a better than 50/50 chance of beating the market. However, there are two main problems to beating the market. First, there are professionals who spend all day, every day, reading and studying, looking for any tiny inefficiencies or arbitrage opportunities, and who pounce on them the second they are available. They act on new information the instant it is announced. So anytime you try and time a stock, or do your own stock picking you are inherently at a disadvantage because the stock price already reflects what these professional investors think is going to happen.

The second problem is just as great, if not bigger. It is the problem of transaction costs. Every time you try to actively pick stocks (or use actively managed mutual funds), you pay higher costs. These higher costs make it so that in order for you to beat the market, you need a higher return to cover the higher costs.

If you put these two factors together, your odds of beating the market actually go down if the market is not perfectly efficient. In a perfectly efficient market, you at least have a random chance. In a less than efficient market your odds go to something more along the lines of less than 30% chance. That is why most people who think about investing think that index funds are the best option. Rather than having a 70% chance of doing worse than the market, I will take the market average. Plus, index funds (especially from places like Vanguard) have the lowest fees of almost any investment vehicle.

So, yes, Tomorroful is right that by making the safe bet, you are not going to beat the market. However, that doesn't mean it isn't the smart bet. Also, I disagree that you are not going to get rich. The average market return for the stock market is around 10% over the past 80 or 90 years. If you invest regularly, the magic of compound interest could well make you rich by the time you retire.
posted by bove at 7:59 AM on June 18

Well, the standard line that commission-based brokers will feed you is exactly what Tomorrowful said: a hotshot fund manager can beat the market average through active portfolio management that gets the best of the best in bull years and the best of the worst in bear years. Certainly, this is true, for some funds in the short term. But actively managed fund's managers are paid more for their trouble. And the overwhelming majority of actively managed funds don't beat the market average in the short term, let alone the long term. But fund managers and brokers need to get paid. There's actually quite a conflict of interest between what is best for you and what is best for the investment houses.

However, I respectfully disagree with Tomorrowful's comment that "You will not get rich with index funds". If you are disciplined, you will get rich (barring a total catastrophic collapse of the US economy, at which point you need to worry about more than just your retirement funds). You just won't get rich overnight. If you don't believe me, ask Warren Buffet. There really isn't a catch--but the industry has vested interests in convincing you that there is. Don't listen.
posted by jtfowl0 at 8:04 AM on June 18

There's no real catch. Index funds, like stocks in general, can go up and down a lot. There's no guarantee you'll see the oft-quoted 10% return over any particular time frame, but over the long run it's very hard to beat the expected return of an index fund, particularly if you don't want to spend huge amounts of time educating yourself.

To quote the Motley Fool's article on the topic of index funds:

There's a reason that all these magazines don't tell you how simple mutual fund investing really is. Scientific marketing surveys and focus group testing have determined that magazines with covers that read "Index Funds: Still The Best Choice!!!" every single month really wouldn't sell as well as magazines that promise "Our BRAND NEW 10 Best Mutual Funds To Buy RIGHT NOW!"

posted by justkevin at 8:08 AM on June 18

bove is quite right. "Picking stocks is stupid" is such an article of faith for me that I may not have been sufficiently sarcastic about it, and his explanation of why index funds are good for everyone is spot-on.
posted by Tomorrowful at 8:13 AM on June 18

I'm a proponent of index fund investing, as I've repeated on AskMe many times. But if I could think of one major drawback to that strategy, it is ikkyu2's point #2 (that an index fund will invest in companies you may consider socially irresponsible). I'd take that concept a bit further and say that passive investing is yet another mechanism that de-democratizes corporate governance. In the case of shareholder votes, shares owned by index funds will mostly likely be voted according by proxy service companies like ISS.

Actively managed mutual funds and pension funds also use services like ISS, but at least there's the possibility for a human to intervene for particularly important votes.

I think this is a serious problem for the capital markets, but I don't think it's really something that should influence individual investor asset allocation.
posted by mullacc at 8:19 AM on June 18 [2 favorites]

If you are making regular contributions (monthly, quarterly, even annually) cost averaging becomes your friend. When the market has a down year, you are buying more shares of the index on the cheap. Then when the market goes back up, you are golden.

In other words, you don't care if the market goes down, even substantially, in the short term, because it means a good deal for you. On October 19 1987, the stock market lost more than 20% of its value in a single day. If you had bought the index on October 20, by the end of 1989 you would have made something like 30% on that chunk of funds.

If you pay attention to which stocks are particularly out of favor, you can invest a portion of your regular contribution in a sector index. For example, right now you might want to be buying a few shares of a financial index, in addition to the S&P 500.
posted by kindall at 8:21 AM on June 18 [1 favorite]

But if I could think of one major drawback to that strategy, it is ikkyu2's point #2 (that an index fund will invest in companies you may consider socially irresponsible).

If this bothers you, then short the SINdex. (It's just what it sounds like: an index of companies that do bad things.) There's an ETF for it, PUF, which can be shorted. Of course, you will probably be giving up a substantial portion of your gains, since those companies often outperform the market.
posted by kindall at 8:26 AM on June 18

I can't find a source for this, but I think it was in A Random Walk Down Wall Street, whose author, Burton Malkiel, is also a strong proponent of index funds. Apparently there is such a demand for the stocks that make up the S&P 500 that when a stock is added, its price immediately goes up about 20%; if it is dropped from the index, there is a similar decline. This suggests because of the strong demand for the stocks in the index, they trade at a premium over other stocks not in the index. Because of this, one risk is that you pay that premium by investing in a S&P 500 fund. Malkiel suggests investing in a Russell 5000 fund instead, as there are a wider choice of stocks and less demand for them.
posted by procrastination at 9:22 AM on June 18 [1 favorite]

If you have enough money you can go to a firm that will basically create an index fund for you. This means you can exclude companies you don't want. Account minimums are around a million right now, I think just because the software is new and not many firms utilize it. I expect them to come down in the next couple of years, but we'll see.
posted by small_ruminant at 9:37 AM on June 18

There really is no "catch" ... at least, nothing beyond the inherent risks of putting your money in the stock market versus FDIC or Treasury-backed investments.

Fund managers will tell you that their managed funds can beat the market. In a limited sense, they are correct: some managed funds do beat the market, and thus market-driven indexes (indices?) like the S&P 500. However, it is extremely difficult — I would say impossible — to know which funds are going to beat the market in a given year. IMO, mutual fund-picking is right up there with stock-picking. In some ways, worse: when you add the ridiculous expenses that managed funds charge you for (generally regardless of the fund's performance!) they start looking to me like a device for separating fools from their money.

If you're basically a lazy investor (like I am), looking for both the maximum return on your money but also on your time (i.e. you don't want to spend a lot of time choosing among thousands of managed funds), I don't think you can do much better than just tossing your money in the Vanguard 500 and letting it ride.

Of course, this assumes that your risk tolerance is high enough to withstand normal whole-market fluctuations, including the possibility of a serious recession that might take a decade or more to recover from. If you're closing in on retirement or might need the money for a catastrophic expense, you obviously need to look at products that have less risk.

The only market that I really see for managed funds, are the "ethical" ones that are driven by some non-financial metric. If knowing that you're profiting from the success of Exxon-Mobil, Monsanto, Alliant, Microsoft, or whomever you find objectionable appalls you, then it might be worth paying somebody to manage your investments in accordance with your beliefs. But that's a choice that's really outside the envelope of finance as such.
posted by Kadin2048 at 9:53 AM on June 18

I'll go one further; if you are already super rich there are probably better investment opportunities out there than an index fund. However, if you were already super rich you would not be asking this question.
posted by Justinian at 9:59 AM on June 18

Oh, I'm betting on Bank of America today. Cash flow is good. Insider trading activity shows confidence. Management is claiming the dividend can be sustained unless the whole economy tanks. The dividend yield is approaching 10%. I'm going to look either really smart or really stupid in a year.
posted by Justinian at 10:01 AM on June 18 [1 favorite]

If you do invest in index funds, be sure to pay close attention to the costs of the fund. My personal favorite is Vanguard usually shows up at the top of the list for being a well managed fund family with very low costs. I suggest that you compare them to what ever other funds you are looking at. Remember that costs of a percentage of the total amount invested (not the earnings) so a 0.5% difference in costs could be the difference between a 5% and 5.5% return on your money.

One other options if you are going to just buy the shares and let them sit there for years is ETFs, or exchange traded funds. They are about like a mutual fund but you buy and sell the units like stock. This means there is a commission on the purchase and sale but minimal on-going costs. There are also some advantages in terms of timing on your capital gains but that doesn't matter if the money is in an IRA.
posted by metahawk at 10:15 AM on June 18

I've heard second hand of academics who make a living studying this stuff say that index funds really are the best option in terms of balancing risk vs. reward.

In fact, some of them even advocate borrowing money in your 20s to put in index funds, as the leverage effects on top of compounded gains can double your money at retirement. Same line of thinking as real estate, but without the inherent risks or liquidity problems.
posted by NoRelationToLea at 10:28 AM on June 18

Just as an aside: here in the UK, we have the FTSE4Good Index series and several index funds track its various indices. The best of both worlds for the shrewd ethical investor!
posted by dogsbody at 10:31 AM on June 18

Philip Greenspun (professor and excellent photographer) has an entertaining article on investing posted on his website. He is strongly in favour of index trackers:

"Anyway, the long and the short of it is that the index outperforms 85 percent of actively managed mutual funds...

Besides getting a higher average return, there are many other good reasons to invest your money in index funds. The first is psychological. When I had individual stocks, every time a stock went up, I attributed it to luck. Every time a stock went down, I attributed it to idiocy on my part. I felt dumber and dumber with every passing year because I ignored the stocks that went up and focussed on the ones that dived. Some Wall Street types have the opposite psychology: they only remember their winners and hence come to think of themselves as Einsteins after five years. Whatever your psychology, there is a certain inner peace to be achieved by forgetting about your money.

Another reason to index is to free up time to make more money. In every office there is at least one sorry loser checking the market every ten minutes, going home at night to read financial reports, running charts, and buying software to manage his complex portfolio."
posted by sindark at 1:31 PM on June 18

One catch that I didn't see mentioned is a lack of diversification. If you have money in just one index fund, you run the risk of losing more than you should when that segment of the market performs poorly.

Here's what Vanguard has to say on it: The proportions of large-, mid-, and small-capitalization stocks in your portfolio differ from those of the market. This puts your portfolio at risk of underperforming the market when the underweighted portion of your portfolio performs well or when the overweighted portion of your portfolio performs poorly.

(The same could be said for another dimension of diversification: investment style (value vs. growth). But, index funds are generally (always?) blends of the two and diversified that way by default.)
posted by roofone at 1:42 PM on June 18

kindall wrote:

Of course, you will probably be giving up a substantial portion of your gains, since those companies often outperform the market.

Hence, all the world's problems...

I have a big problem with having to invest my 401K with operators who encourage the amoral behavior of corporations. I've felt for years that the value of oil and defense contractors were going to skyrocket due to the war yet I could not bring myself to invest in companies like Halliburton because I consider this profiting off the blood of innocents. We will continue to degrade as a race the longer we continue to shelter our conscience with Mutual/Hedge funds who invest in companies that see dollar signs where others see tragedy.

There used to be a time in this nation when less that 5% held stocks now that number must be well over 50%. I believe the more of us own stock the more silent we become to the ammorality of corporations because ownership makes us complicit.
posted by any major dude at 1:50 PM on June 18

The catch is, you will not do as good as is theoretically possible. If you spent X hours a day researching companies and sectors to invest in, and continuously readjust, you might to better than an index fund. But if you don't have that kind of time or talent, then doing it yourself will fail. As will putting it into a mutual fund that may not have your long term interests in mind.
posted by gjc at 8:16 PM on June 18

[a few comments removed - don't do this here. if you are not answering the question can you pleas take side discusisons to email or metatalk? thank you.]
posted by jessamyn at 8:23 AM on June 19