Index Funds Pros and Cons

[Rich_in_Tampa]

Originally Posted by ats5g

See myth #4 Index Funds always underperform in a bear market from Vanguard's Myths and Misconceptions about Indexing.

Well, that was and is my impression (i.e. that they do fine in any conditions relative to active funds).

Not to doubt anyone's personal experience -- I am sure you can find many exceptions. But as a future decision guide, I really try to stick to the available studies. I've yet to see figures showing that index funds under-perform in a bear market.

Still, it's helpful to learn of others' experiences. So far, index funds continue to sound right for me.

[FinanceDude]

Originally Posted by ats5g

I haven't seen much evidence of active funds moving to cash right at the right time before a bear market.

There are some that do a good job of that, but no one on here wants to beleive it.........besides, the index folks can always fall back on the premise that "well, that market's down, and we're fully invested, so what do you expect"? I think a mix of index and non-index is the right way........

[FinanceDude]

Originally Posted by justin

I can buy any vanguard fund I want for a flat fee of zero.*
I did see that statement about American Funds from Bogle (I think in "common sense on mutual funds").* I like them, just I think I can get similar or better equity/bond exposure at Vanguard for much less (no load plus lower expense ratio).* I still hold low six figures worth of American funds (it is the bulk of my portfolio right now, as I'm focusing on acquiring VG and Fido funds right now).

Well.............I should have said, I can buy my clients any Vanguard fund they want for $50............I can buy them for $0.............

I have a lot of American Funds too..............but, as an advisor, I can buy at NAV, so it's a good deal for me...............

[FinanceDude]

I'm a little late to this discussion, but I wanted to bring up a few points:

1)Low expenses - I see this trumpeted as THE REASON to own index funds. Fact is, how hard is it to buy the 500 stocks of the S&P 500 in the right weightings to track the index? I think anyone on this board that has any financial acumen at all could handle that. You really don't need analysts or a lot of backoffice support, since the decisions about who is in the S&P or who gets kicked out is handled by a committee. Fact is, you wouldn't PAY 65-75bp a year to an index fund, because they're NOT TRYING to beat the market.............

2)Managed funds - does anyone here besides brewer think they could run one of these? I submit it's a lot harder to beat the index than most think, and as a matter of fact few do. Throw in the expenses to pay research teams, higher transaction costs of moving stocks all the time, etc...........and it's easy to see why they charge a much higher expense................

Not to say anyone has to buy indexed or managed, just pointing out logical evidence................

[justin]

Originally Posted by FinanceDude

1)Low expenses - I see this trumpeted as THE REASON to own index funds. Fact is, how hard is it to buy the 500 stocks of the S&P 500 in the right weightings to track the index? I think anyone on this board that has any financial acumen at all could handle that. You really don't need analysts or a lot of backoffice support, since the decisions about who is in the S&P or who gets kicked out is handled by a committee. Fact is, you wouldn't PAY 65-75bp a year to an index fund, because they're NOT TRYING to beat the market.............

Expenses and costs matter. Good luck buying 500 stocks every month or quarter or year as you accumulate assets during your working years. I think I'll stick to paying 10-20 basis points a year to fidelity and vanguard in exchange for this service. Buying individual stocks in the SP500 is relatively simple when you compare it to buying the 5000 stocks in the Wilshire 5000, or all the stocks in the MSCI EAFE or the MSCI Emerging Markets Index (all of which can be had for 30-45 basis points).

Originally Posted by FinanceDude

2)Managed funds - does anyone here besides brewer think they could run one of these? I submit it's a lot harder to beat the index than most think, and as a matter of fact few do. Throw in the expenses to pay research teams, higher transaction costs of moving stocks all the time, etc...........and it's easy to see why they charge a much higher expense................

I know with a high degree of certainty that I could run an above average "managed fund". All I'd have to do is put out some glossy brochures about "superior outperformance", market diversification, outpacing inflation, careful security selection, blah blah blah. Then go buy a couple of index funds from VG institutional and be home at 5:00 for dinner.

The sad thing is that is the recipe for outperforming most actively managed funds.

You say "I submit it's a lot harder to beat the index than most think, and as a matter of fact few do". Then what is the point of paying out the wazoo for active management when so few can outperform the index?

Bottom line is that since you are a financial planner making big bucks off of commissions, what are you going to recommend? American Funds with a 5.75% front end load and a residual 0.25% payment every year from the 12b-1 fee or a Vanguard index fund with a $50 fee and much lower long term expenses? If I was in your shoes, I know which one I would recommend. At least be honest about your motives.

[brewer12345]

FD, I can see only a few reasons to buy a managed fund, especially snce there is such a proliferation of index funds these days:

- When a managed fund offers exposure to an asset class that you cannot buy an index fund for. I'm still waiting for a non-USD bond index fund, so in the meantime I choose to own GIM. Still waiting for the Venezuelan Beev3r cheese futures index fund...
- When the asset class is very illiquid/idiosyncratic. High yield munis is something I would want a very sharp manager running, not an index.
- When the active manager is willing to work cheap and appears to have a good track record. I am thinking of Wellington, for example.

That's about it. Other than that, I suppose you can make a case that you have found a truly superior manager running a mutual fund, but I reserve the right to be skeptical/laugh at you.

[Rich_in_Tampa]

Once paid a guy 1.5% management fee at Bernstein-Alliance for virtually all my investments. He has actually outpaced the index by a small bit for a couple of years, net of fees. As I got smarter I realized that with my fixed income allocation, he was putting it in the Bernstein bond mutual funds; so I was not only paying the fund's expenses, but also 1.5% on an investment returning maybe 5%.

I talked this over with him, and he -- to his credit -- agreed that I'd be better off handling that piece on my own (which I'd already told him I was going to do). He added something about how it's something they do for investors who prefer to have one-stop shopping, etc.

So I pulled my fixed income out. At 59.5 years of age, I'll probably roll over the equities he still manages for me to my Vanguard IRA but since he's doing OK with it for now (even after fees), no rush. These are invested directly in (many) individual stocks, so part of that 1.5% would be offset by mutual fund fees if I did it myself.

It's been a weaning process for me. The most reassuring evidence that I can do this all myself (without active management from either an advisor or fund managers) is that everytime I look at the stock market, the Bernstein account has done almost the same as the relevant indices. Haven't lived through a bear market with him yet, though.

[FinanceDude]

Originally Posted by justin

Expenses and costs matter.* Good luck buying 500 stocks every month or quarter or year as you accumulate assets during your working years.* I think I'll stick to paying 10-20 basis points a year to fidelity and vanguard in exchange for this service.* Buying individual stocks in the SP500 is relatively simple when you compare it to buying the 5000 stocks in the Wilshire 5000, or all the stocks in the MSCI EAFE or the MSCI Emerging Markets Index (all of which can be had for 30-45 basis points).*

You missed my point entirely. What I was saying was YOU would not PAY Vanguard 65-75 basis points a year to buy the 500 stocks of the S&P.............it is NOT HARD to do for Vanguard or anyone else.................and takes little thought and trading.............

I know with a high degree of certainty that I could run an above average "managed fund".* All I'd have to do is put out some glossy brochures about "superior outperformance", market diversification, outpacing inflation, careful security selection, blah blah blah.* Then go buy a couple of index funds from VG institutional and be home at 5:00 for dinner.* ** *

You say "I submit it's a lot harder to beat the index than most think, and as a matter of fact few do".* Then what is the point of paying out the wazoo for active management when so few can outperform the index?*

Bottom line is that since you are a financial planner making big bucks off of commissions, what are you going to recommend?* American Funds with a 5.75% front end load and a residual 0.25% payment every year from the 12b-1 fee or a Vanguard index fund with a $50 fee and much lower long term expenses?* If I was in your shoes, I know which one I would recommend.* At least be honest about your motives.

First of all, I work on fees, not commissions...........second, you can find companies that outperform the S&P quite handily............Dodge and Cox come to mind, and others. I appreciate the Vanguard passion, but don't be so close minded, I don't recall anyone paying 5.75% to buy Dodge and Cox or T Rowe Price in recent memory.........I have done better in my managed funds the past 7 years than any Index fund I own, Vanguard included............

To each their own..................

[astromeria]

I also have some $ with a broker (it was originally 20% of our port) in individual corporate bonds (and in 2003 when bond coupons were bottomed out, I got a 10-year CD and IGR--global REIT fund--which she sold me out of just before the big growth spurt this year ). Since we're not living off the proceeds yet, and I haven't bought anything new with her for over a year, I take the income and capital from called/sold bonds to invest myself. Eventually this account will practically close itself (I'm such a wimp-).

[FinanceDude]

Originally Posted by Rich_in_Tampa

Once paid a guy 1.5% management fee at Bernstein-Alliance for virtually all my investments. He has actually outpaced the index by a small bit for a couple of years, net of fees. As I got smarter I realized that with my fixed income allocation, he was putting it in the Bernstein bond mutual funds; so I was not only paying the fund's expenses, but also 1.5% on an investment returning maybe 5%.

I talked this over with him, and he -- to his credit -- agreed that I'd be better off handling that piece on my own (which I'd already told him I was going to do). He added something about how it's something they do for investors who prefer to have one-stop shopping, etc.

So I pulled my fixed income out. At 59.5 years of age, I'll probably roll over the equities he still manages for me to my Vanguard IRA but since he's doing OK with it for now (even after fees), no rush. These are invested directly in (many) individual stocks, so part of that 1.5% would be offset by mutual fund fees if I did it myself.

It's been a weaning process for me. The most reassuring evidence that I can do this all myself (without active management from either an advisor or fund managers) is that everytime I look at the stock market, the Bernstein account has done almost the same as the relevant indices. Haven't lived through a bear market with him yet, though.

Bottom line is, you paid someone to manage your money for you until you had the time/felt comfortable doing it, and that's the key.

I have some clients I have told to manage their own money, and have helped them set up the accounts to do it. I'm not going to fight anybody who thinks 1% a year on their assets is too much to pay........life is too short............

[justin]

Originally Posted by FinanceDude

You missed my point entirely. What I was saying was YOU would not PAY Vanguard 65-75 basis points a year to buy the 500 stocks of the S&P.............it is NOT HARD to do for Vanguard or anyone else.................and takes little thought and trading.............

I thought your main point was "how hard is it to buy the 500 stocks of the S&P 500 in the right weightings to track the index?". I'd say pretty hard for an individual investor. It would take me probably two days at least to determine the correct quantities of the 500 stocks to buy and to execute the trades and then I'd have to pay thousands in commissions. Vanguard (and other indexers) provide a very valuable service for 10-20 basis points. My point is that it is impractical for most individual retail investors to buy all the components of indexes.

[justin]

Originally Posted by FinanceDude

First of all, I work on fees, not commissions...........second, you can find companies that outperform the S&P quite handily............Dodge and Cox come to mind, and others. I appreciate the Vanguard passion, but don't be so close minded, I don't recall anyone paying 5.75% to buy Dodge and Cox or T Rowe Price in recent memory.........I have done better in my managed funds the past 7 years than any Index fund I own, Vanguard included............

Good luck continuing your outperformance for you and your clients. Watch out for Dodge and Cox - their performance has dropped like a rock in the last 6-9 months. The days of their funds being in the top 5% in their fund categories are over. Another story of how the party was great as long as it lasted. Problem is, everyone was late to the party.

I do think Dodge and Cox and other actively managed mutual funds (TRP, American Funds Class A ignoring the loads, etc) who have relatively low expense ratios will continue to do ok - above the 50th percentile as long as their ER stays low.

Let me know if you have any "hot picks" for funds that will be in the top 5% over the next 5-10 years. I think you'll have a lot of receptive ears here.

[terminator]

Even if you are a true believer in Bernstein, there are times it can make sense to do it on your own. *If you are beyond the early and small accumulation phase and willing to live with the volatility that Bernstein shows in his charts from owning a smaller number of diversified stocks, there's no reason you can't do it yourself.

Cost example: buy 50 positions averaging $20k each. *That's $1MM (a realistic sized portfolio). *50 buy orders at a discount broker would cost about $500. *That's .05% expense which is lower than the lowest annual index fund fee. *Unless you churn like crazy (in which case you shouldn't be doing it yourself), your expenses will be lower. *It is easy to administrate these days if you hold them all in a brokerage account. *You get to make the tax decisions for yourself.

Our OP could buy 25 $10k positions for an expense of .10% and just continue adding positions with each additional $10k.

The downside is you might have greater volatility and (for diehards) you might be worried about not getting a return that is identical to market return. *If you can live with those potential downsides and like the upside of completely controlling your tax destiny, having marginally lower expenses and having more control over what you hold, then doing it yourself might make sense.

Of course it's all colored by our past experiences as well. *Managing my money myself I've beaten the S&P returns for the last 15 years on the stock portion of my portfolio so even if I revert to the average or slightly below, I'm not worried since I'll still be ahead. *Someone who owned tech stocks and watched 50% of their life savings disappear in a year or two would probably be more comfortable putting it on auto-pilot in index funds.

[Nords]

Originally Posted by Spanky

Over the long term, Index funds tend to outperform their counterparts because of the cost advantage. However, the actively managed funds perform slightly better during a bear market since they have the freedom not to be fully invested in the market. During a bull market, the actively managed funds tend to do worse since they may be late in getting back. The following link has an explanation about this.
http://news.morningstar.com/article/...15580&_QSBPA=Y

Whenever I read reassuring "studies" like this one, I wonder if the money saved by those nimble actively-managed funds during bear markets exceeds the fees collected during all markets.

As for American or Dodge & Cox, one word: bloat. You can't bloat an index fund.

[justin]

Originally Posted by terminator

Even if you are a true believer in Bernstein, there are times it can make sense to do it on your own. If you are beyond the early and small accumulation phase and willing to live with the volatility that Bernstein shows in his charts from owning a smaller number of diversified stocks, there's no reason you can't do it yourself.

Cost example: buy 50 positions averaging $20k each. That's $1MM (a realistic sized portfolio). 50 buy orders at a discount broker would cost about $500. That's .05% expense which is lower than the lowest annual index fund fee. Unless you churn like crazy (in which case you shouldn't be doing it yourself), your expenses will be lower. It is easy to administrate these days if you hold them all in a brokerage account. You get to make the tax decisions for yourself.

Our OP could buy 25 $10k positions for an expense of .10% and just continue adding positions with each additional $10k.

If you have a million laying around, you can probably find an institutional fund with a 0.05% expense ratio. I know Fidelity has a number of Spartan Advantage class funds with ERs of 0.07% and only $100k minimums. The advantage of the mutual fund ownership structure is that you can sell and buy shares with no additional transaction fees (unlike a stock portfolio).

[haha]

Originally Posted by FinanceDude

I have some clients I have told to manage their own money, and have helped them set up the accounts to do it.* I'm not going to fight anybody who thinks 1% a year on their assets is too much to pay........life is too short............

Do I understand that they pay you 1% for your services? If so they are not giving up 1% per year; they are giving up 1% plus whatever the fund level or stock level expenses are. So pre-tax, they are giving up at least 1.5%.

Even if you believe that 4% is a conservative SWR (which I don't), your clients are giving up 1.5% of that 4%, or almost 40% of their SWR! It's not for nothing that expenses and fees are always expressed as a % of assets, not as a % of average returns. And 25% of their SWR goes to your fees, which while important to you, really accomplish nothing that the client couldn't accomplish with a bit of reading. He could just come to this board and take Wellington. It may not be perfect, but it isn't bad and it is cheap.

I would say that the clients' lives may be too long for them to really be able to afford that kind of thing.

Not that I* think you shouldn’t get your fees however you can, but caveat emptor does apply here as in most places.

Ha