Help me figure out why index funds are better...

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yuag

Dryer sheet wannabe
Joined
May 30, 2008
Messages
13
I normally invest with a financial advisor through a large brokerage, and would like to weigh my options. Based on all the advice I've been given, I should eventually make the switch when the time is right and mainly invest in index funds, as it's the easiest, 'set it and forget it' way to go. Anywho, I just put together a little chart (got the numbers from Google Finance) of 2 index funds (Vanguard Total Stock Index, Vanguard Total Value Index) and compared those to 4 Loaded funds I'm currently invested in. Granted they're not as diversified as the two mentioned above, but then I compared the YTD, 1y, 5y and 10y returns for all of the funds.

What confuses me, is for the most part, the further out you go, it appears that the loaded funds appear to perform better. is there something I'm missing? (sorry for the terrible formatting, I did it to try and make them line up better.)

Name***(Load)*** YTD *****1y***** 5y**** 10y
VTSMX** (N/A) **(-4.03)** (-5.45)** 8.44** (-1.15)
VIVAX** (N/A) ***(-15.5) *(-22.67)**30.39**(-3.31)
ABWAX**(A) *****(-9.59)* (-13.05) *22.55*** N/A
FNIBX** (B) *****(-8.56)**(-2.87)** 59.45**** N/A
EMHSX**(B) *****(-5.01)**(-19.03)***0.69** 159.13
EACFX** (C) *****(-9.77)**(-12.57)** 18.26* 31.85
 
Careful- getting into an index vs managed fund debate here can be hazerdous to one's health.

I use managed funds myself, but I tend to avoid that topic around these parts.
 
Expense ratios, for one thing. And another would be how much faith you have in your ability to pick 'em.

Best way to really educate yourself on this topic is to pick up a good book and read it. I recommend "The Four Pillars of Investing".
 
The "index vs managed funds" debate is one we've had often here. I recommend you check the FAQ forum, as you'll find a bunch of theads on this subject.

In a nutshell, the comparison you've done doesn't tell you much. Index funds have lower costs, and proponents of index investing (myself included) strongly believe investors can do best by choosing an overall asset allocation that fits their risk tolerance, then putting their money onto index funds that will fill out the desired allocation. Looking backward to determine which funds are "best" isn't the best way to pick funds. It's a common mistake (I did it, too--subscribed to all the "which funds are hot now" lists, too).

I second the recommendation for "The Four Pillars of Investing."

Good luck, and welcome.
 
With certainty, which actively managed funds will do better over the next 5 years?

(And if you're that good, skip the funds altogether and pick which individual stocks will do better over the next five years.)

Also, your comparisons are invalid. Why are you comparing a sector specific fund to a total market fund? You could have just as well compared VTSMX to CVX and declared indexing dead.
 
yuag said:
could you perhaps elaborate? :)
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for starters (in addition to the comments of others above), for the 10 yrs ended 6/30, the average annual returns are
VIVAX 3.79%
VTSMX 3.54%
EMHSX 10.35%

there are no 10 yr returns for EACFX so i'm confused as you report there are.

it's hardly apt to compare a nominally "world wide" sector fund to diverse domestic funds.
 
eridanus said:
Also, your comparisons are invalid. Why are you comparing a sector specific fund to a total market fund? You could have just as well compared VTSMX to CVX and declared indexing dead.
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I know it's a bad comparison with the specialty fund thrown in (EMHSX). I used to work for a health care company and figure with baby boomers getting older there would be more focus in that sector as time goes on. I didn't cherry-pick those funds, they were recommended through my advisor and happen to be what I'm in now. 99% of what I've heard said Index funds are the way to go, which is why I brought up the debate...I know 99% can't be wrong so I know there has to be some flaw in what I mentioned about the funds I am in.
 
I think you'll be a lot happier if you read "The Four Pillars of Investing" or another solid book on this.

There's no short-cut to this--if you want to avoid the high advisor fees you are paying now, plus the loads and fees in the funds your advisor is recommending, then the best thing to do is to study up a little. It is not as simple as just "investing in index funds"--you could easily invest in highly-focussed index funds that are entirely inappropriate for your situation and you could lose a lot of money.

Your options:
- 1) Do some reading (here, in the recommended books, at some good sites like The Online Asset Allocator or Investment Strategies for the 21st Century, by Frank Armstrong ), then build a solid portfolio of low cost index funds and other assets. You'll be in charge of things and understand what your investments are doing for the rest of your life. Play with them as much or as little as you want, you can easily keep everything humming along with as little as 20 hours of work per year, and you'll save tens of thousands of dollars in fees and costs over a typical multi-decade investing career. But, you have to be willing to do a little reading.

- 2) Choose one Vanguard Target Retirement fund and put your retirement savings into it. These funds hold a wide variety of assets (stocks, bonds, REITS, etc) so your savings will be diversified. They'll do all the rebalancing for you, and you'll come out better than probably 80% of investors who try to beat the market by guessing what the next hot fund is going to be. The fees are very low. You won't need to understand the details of what is going on, but if you leave the money in there and don't get panicked by something you heard at work or take your money out to invest in a hot tip, you'll be fine.

- 3) Stay with your broker, still have no idea what is happening with your investments (or if he/she is giving you good advice), and make him/her and the brokerage houses who are selling the high-expense products to you very rich in the bargain.
 
Random chance guarantees some managed funds are going to look better than their matching indexed funds over the past 10 years, just by pure luck. That's one thing that makes some managed funds look attractive.

On the other hand, you are not just pulling out the "best" managed funds, you are comparing to funds you already own. That takes most of the "luck" factor out of the equation.

Be sure to compare with indexes that match your funds as closely as possible. If your funds compare favorably and are not outrageously expensive, maybe your managers really are earning their money. I wouldn't mind staying in funds like that.

The 10yr performance includes the big drop in 2000-2002, hopefully a time when active management might have helped. Your funds probably made good decisions during that period, making their 10yr performance look good. No guarantees they will do it again, but that's better than totally blowing it in 2002!
 
CitricAcid said:
... you sure?
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of course i'm not....which is why I asked on the forum. however I think I see the flaw in my data in the original post...i only went back 10 years. perhaps if I had gone back further, the numbers might be different. 10 years is probably still too short a tiem frame to do the comparison that I did.

I've gone ahead and added the book to my to-do list and will do more research. i think for the time being i'll keep what I have on hold on the loaded funds, but not necessarily take them out just yet. i know i'm losing money to fees and expenses while I wait, but it'll give me time to learn what I don't know.
 
OK, here is the big thing about looking in the past. The big thing that most people use to determine which is better is because of the expense ratios. Over the long haul, it is said (and I agree, just saying neutrally) that throwing darts at a board is essentially as good at beating the market (a coin flip) as individual managers. This could be true, and for every mutual fund that fails in a sense (we'll use S&P 500 as an example) buying some S&P 500 stocks, another one will succeed because it is not bogged down in that sense. Thus, usually you will find a LOT of actively managed funds that beat the index funds. The big problem, however, is that over the long haul, these benefits tend to balance out. And, if a money manager manages to find a VERY slight advantage over the market in the long haul, a lot of the benefits are mitigated in the differences in expense ratios.

So, if you look at a one-year projection of mutual funds who pick out of S&P 500 stocks, it would probably be about 50-50 who beats the S&P 500. Do a two-year and it's only about 25% who consistently beat it, 3 years 12.5% and over time the expense ratios bring them back to the mean. Also, survivor bias is a term thrown around. You look back on the companies that are around TODAY looking ten years back. You don't look back on the ones that don't exist TODAY because they did so poorly. You CAN beat the market, it is just dang near impossible to pick which manager/fund WILL beat the market.
 
well i've also come to accept the fact that it makes more sense to keep up with the market instead of trying to beat it. in order for an individual to beat the average, they have to do something better than that average return. in order to do better than that average return, that means there has to be some other guy who does worse than the average return. since the odds are that it's much easier to do worse than it is to do better, i'd rather just have funds perform as well as the market.
 
eridanus said:
With certainty, which actively managed funds will do better over the next 5 years?
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Conversely, tell me which index funds will do better than my managed ones..........:D

(And if you're that good, skip the funds altogether and pick which individual stocks will do better over the next five years.)
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You can make a LOT more in individual stocks than any kind of mutual fund, but the risk is higher and most folks won't like the ride.........
 
I think you bring up a good point...let's take individual stocks out of the question for a moment...because of the risk involved.

I would say it's safe to assume that overall the risks are comprable between active and index funds. Now, in the short term, I think you have a good arguement, it's really anyone's game.

However, I am making an assumption (and I haven't done any research, it's just an assumption on what I've hard on recent podcasts and magazine articles) that over the long-term index funds always outperform other actively managed mutual funds...and over the long-term value funds perform better than growth funds. now in the short term anything is game, but my assumption is over the long-term that is true. I'd have to do more research to back that up however.
 
yuag said:
i only went back 10 years. perhaps if I had gone back further, the numbers might be different. 10 years is probably still too short a tiem frame to do the comparison that I did.
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You'll find this difficult to do because of survivorship bias. If an active fund doesn't do well, it gets the axe. Take a look at SCUTX, for example. Ooops, closed down. :( But, damn, it did great in the dot com boom.

Now you just have to know when to get into the soon-to-be-hot funds and when to sell them.
 
yuag said:
well i've also come to accept the fact that it makes more sense to keep up with the market instead of trying to beat it. in order for an individual to beat the average, they have to do something better than that average return. in order to do better than that average return, that means there has to be some other guy who does worse than the average return. since the odds are that it's much easier to do worse than it is to do better, i'd rather just have funds perform as well as the market.
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Exactly. Stick to that mindset, learn how to implement it (it's not hard, but there will be a lot of temptation along the way), and you'll be fine.

Sometimes the worst thing that can happen to an investor is to have a period of great, market-beating returns using in a stock-tip sheet or a managed, highly-concentrated mutual fund. They become convinced, like a first time lotto player who hits big, that they can beat the averages. The rest of the story --years paying higher fees, trading costs, the extra tax burden incurred when trading, etc--produces results which usually are substantially worse than a simple, well-diversified, low expense portfolio would have brought them.
 
makes more sense to keep up with the market instead of trying to beat it. in order for an individual to beat the average, they have to do something better than that average return.
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As long as you understand what 'the market' is. What is your understanding of the market? Many uninformed anti-indexes beat the dead horse of the s&p500 as the 'market' that their fund du jour is beating up on.

over the long-term index funds always outperform other actively managed mutual funds.
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Its a tricky thing, but indexes do not always outperform. They outperform the vast majority - there are still winners here and there in the active segment that manage to outpace an appropriate comparator index over the long term. The trick is choosing which active fund will be among the few winners 20 years in advance.

I am a diehard indexer (in fact, check out diehards.org if you want to be in company of others who feel the same way), but there are appropriate uses of managed funds I can think of. If you feel you need access to a market sector that you cannot obtain in an index, I would be comfortable using a low cost (< 0.60 expense ratio), no-load managed fund to do it.

Most important thing when comparing active vs. index is to get an apples to apples comparison. Many managed 'US Large Cap' funds appear to be aptly crushing the index over a span of time - when you look closely you'll see them sneaking dollars into foreign markets to boost their returns. This 'style creep' has the effect of changing your risk/return profile of your portfolio and you now have lost control of your asset allocation.

Two other books / authors I'd strongly recommend:
A Random walk down wall street - Burton Malkiel
Anything by Larry Swedroe
 
innova said:
As long as you understand what 'the market' is. What is your understanding of the market? Many uninformed anti-indexes beat the dead horse of the s&p500 as the 'market' that their fund du jour is beating up on.
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correct me if im wrong but i took the market to be a fund like VTSMX. To me the S&P 500 is a smaller segment of that...500 large cap companies.
 
yuag said:
correct me if im wrong but i took the market to be a fund like VTSMX. To me the S&P 500 is a smaller segment of that...500 large cap companies.
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While the name of VTSMX is "Vanguard Total Stock Market Index Fund," and it does hold a large number of companies, investments in it will be cap-weighted, which means you'll own primarily shares in large companies. As you say, it is a good representation of the US stock market. But, most investors would not consider it a total solution to their investing needs (since it holds no international stocks, no bonds, no REITS, etc). Most people agree that international stocks are an important asset class in a well constructed portfolio. The advice was different 30 years ago.
 
samclem said:
While the name of VTSMX is "Vanguard Total Stock Market Index Fund," and it does hold a large number of companies, investments in it will be cap-weighted, which means you'll own primarily shares in large companies. As you say, it is a good representation of the US stock market. But, most investors would not consider it a total solution to their investing needs (since it holds no international stocks, no bonds, no REITS, etc). Most people agree that international stocks are an important asset class in a well constructed portfolio. The advice was different 30 years ago.
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oh i completely agree. i plan to have an overall asset allocation across various types of funds...my next one being international and most likely VGTSX. My options are to build up my liquid cash first or leave my advisor where I currently have loaded funds and use that money to invest in the index funds.
 
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