Index Funds Pros and Cons

[Pale Rider]

I just finished reading The Four Pillars of Investing by William Bernstein. This book was suggested to me by members of this forum. I really enjoyed the book and felt like there was a lot of good investing information to be learned.

I am curious what others think of the approach to investing that is described in this book. Especially in regards to investing in index funds, investing in precious metals, investing in a minimum of 20% bonds, and his repeated recommendation for Vanguard funds.

I am 34 and married. We use a financial planner. We have used him for about 5 years now because we really did not know much at the time. I am learning more and am starting to see the error of my ways. Since reading this book I am thinking of selling my assets (all mutual funds) that I have with my planner and moving them into Vanguard index funds. We have 100K in taxable funds and about 140K in sheltered accounts (Roth IRA's and a VA). I know this is not a complete story, but I would appreciate any opinions on the matter.

Thanks.

 

[REWahoo]

You asked, so...

... investing in index funds

Highly recommended.

... investing in precious metals

Not my cup of tea, but many here swear at by it.

...investing in a minimum of 20% bonds

I would agree with this, but at your age I might be more agressive and skip the bonds for a few years.

... Vanguard funds.

Absolutely. Costs really do matter, so Vanguard or Fidelity are the way to go. Say thanks and goodbye to your financial planner as quickly as you can.

 

[Nords]

I just finished reading The Four Pillars of Investing by William Bernstein.  This book was suggested to me by members of this forum.  I really enjoyed the book and felt like there was a lot of good investing information to be learned.

Keep on reading at Bernstein's website, it gets better!

http://www.efficientfrontier.com/ef/998/hell.htm
http://www.efficientfrontier.com/ef/101/hell101.htm
http://www.efficientfrontier.com/ef/901/hell3.htm
http://www.efficientfrontier.com/ef/103/hell4.htm
http://www.efficientfrontier.com/ef/403/hell5.htm .

And "fire" your financial planner.

 

[d]

i'll ditto both of the previous replies

 

[justin]

I am 34 and married. We use a financial planner. We have used him for about 5 years now because we really did not know much at the time. I am learning more and am starting to see the error of my ways. Since reading this book I am thinking of selling my assets (all mutual funds) that I have with my planner and moving them into Vanguard index funds. We have 100K in taxable funds and about 140K in sheltered accounts (Roth IRA's and a VA). I know this is not a complete story, but I would appreciate any opinions on the matter.

I was in the same position about a year and a half ago. I had a financial planner that I didn't really care to use (nice guy, but I'm a do-it-yourself investor). I had just sold a house and invested the proceeds into more of the FP's load mutual funds at American funds. I paid a few thousand dollars in commissions, and that was the straw that broke the camel's back.

Prior to this transaction, I had asked the FP if he could get me into Vanguard index funds and he said only if I buy the ETF's and pay huge commissions on them. I didn't like the fact that he was only available during regular business hours, and the online interface was very poor and for informational purposes only. I did most of my investment/finance stuff at night and on weekends, so I found the inconvenience of taking time out of my work day to call my broker annoying.

I like the convenience of a person on the phone late at night and on weekends for broker help and account issues, and I use the internet site at VG for 99% of my investment transactions. It's easy to set up automatic investments and deposits and to change these.

Plus, VG saves me thousands every year in expenses and loads.

 

[FinanceDude]

That's a shame..............I can buy any Vanguard fund I want for a flat $50 fee...............

American Funds are an interesting model. I've got to find the Bogle article where he stated they are the ONLY fund company outside of Vanguard he would invest in..............

 

[justin]

That's a shame..............I can buy any Vanguard fund I want for a flat $50 fee...............

American Funds are an interesting model. I've got to find the Bogle article where he stated they are the ONLY fund company outside of Vanguard he would invest in..............

I can buy any vanguard fund I want for a flat fee of zero. Since I buy $750 or so of a mutual fund at a time, the $50 fee per transaction would eat me alive.

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).

 

[grumpy]

Pale Rider,

I would recommend that you first transfer your tax sheltered funds only to Vanguard index funds since you can do this without paying any taxes on capital gains. Be sure to do this as a direct rollover from your existing account to Vanguard. Do not take possession of the funds as this can trigger tax and penalties. Once you see how you like Vanguard and its funds you can decide if it is worth taking the capital gains tax hit to move the funds in your taxable account to Vanguard.

I have used both Vanguard and T.R. Price for all of my mutual fund investing for the last 20 years and have no complaints with either one.

Grumpy

 

[mathjak107]

I like index funds overall although the big negative is that the way the indexs are figured the higher and more over priced a stock becomes the more it weights and dominates the index. The more undervalued a stock the less weight it carries. Many indexes became mini energy funds in the last run up.

 

[mickeyd]

The Four Pillars of Investing by William Bernstein

Best investing book ever written by a human being. Other than that, I can not recommend it at all. 8)

Of the 30-40 or so investment books that I have read over the last 20 years, it still ranks as #1. Index, 20% bonds (for me 40%), Vanguard, but not precious metals. I make my own decisions with the help of many and I do not blindly follow.

 

[mathjak107]

I like his writing although i have to tell you it looks like the format for his book came right out of harry brownes "why the best laid investment plans usually fail"

 

[Spanky]

I am assuming that you are comparing index funds to actively-management funds.

Pros:
low cost
diversification

Cons:
large cap or small cap: may perform worse than actively-managed funds during a bear market.
small cap: may underperform relative to active funds during a bull market.

 

[Rich_by_the_Bay]

Cons:
large cap or small cap: may perform worse than actively-managed funds during a bear market.
small cap: may underperform relative to active funds during a bull market.

Spanky,

Can you provide any generalizeable evidence for this assertion (i.e. not just specific anecdotes where this was the case)? I'd be inclined to add "or may not." Thanks.

 

[dmpi]

I've been tracking the spread between the S&P500 & the RUT 2000, looking to make a hedge bet. Past couple of years the RUT 2000 was beating the S&P, but that seem to have turned around this years. Also on a day to day basis, when the market goes up or down, the RUT goes like 1x-2x the S&P.
I'm starting to suspect the performance of the RUT is largely correlated to manage funds, while the S&P is correlates to the index funds.

 

[Gone4Good]

Cons:
large cap or small cap: may perform worse than actively-managed funds during a bear market.
small cap: may underperform relative to active funds during a bull market.

As Bogle says, managed funds in aggregate will, by definition, underperform the market once expenses are taken in to account.  Some funds will outperform.  More will underperform.  Good luck separating the winners from the losers before the fact.  

My list of pros & cons vs. managed funds:

Pros
1) Low cost
2) Guaranteed market returns
3) Tax efficient
4) No "style creep" (i.e. your large cap manager dabbling in small cap stocks)

Cons
1) You have to get over your fantasies about beating the market.

 

[Gone4Good]

I've been tracking the spread between the S&P500 & the RUT 2000, looking to make a hedge bet. Past couple of years the RUT 2000 was beating the S&P, but that seem to have turned around this years. Also on a day to day basis, when the market goes up or down, the RUT goes like 1x-2x the S&P.
I'm starting to suspect the performance of the RUT is largely correlated to manage funds, while the S&P is correlates to the index funds.

S&P 500 is large cap stocks
Russell 2000 is small cap stocks

Both are indexes.

 

[dmpi]

S&P 500 is large cap stocks
Russell 2000 is small cap stocks

Both are indexes.

I'm interested in the predicting the spread. Why does small caps beat out large caps in some years, but not others? What sort of buyers drive each of the indexes? How come the beta on the RUT is larger than the S&P?

 

[Spanky]

Spanky,

Can you provide any generalizeable evidence for this assertion (i.e. not just specific anecdotes where this was the case)? I'd be inclined to add "or may not." Thanks.

Rich,
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/article.asp?id=115580&_QSBPA=Y

P.S. Most of my funds are indexed except for the following funds:
Vanguard Health Care
Vanguard International Explorer
Oakmark International
Vanguard Wellesly
Fidelity Low-priced stocks


Spanky

 

[mathjak107]

Well speaking for myself i havent been able to come up with any combo of index funds that surpassed the performance of my 20 plus years in active funds.

Lord i keep trying to track a few different lower cost combo's of etf's but so far no cigar.

The problem is not a long enough history yet on some that are very unique like a DVY to really see how they do long term.

All my funds are fairly low cost fidelity funds and overall i think i pay about .70% overall  but considering im well diversified and until last year when i decided to reduce everything down to a 50/50 mix i averaged a very well documentd 13% for 20 years.

I admit i didnt pick these funds myself as i use fidelity insight for my strategy but as i always say "YOU DONT HAVE TO KNOW ALL THE ANSWERES ,YOU JUST NEED TO KNOW WHERE TO GO TO GET THE ANSWERES".

SO I GUESS I CAN STILL TAKE CREDIT RIGHT? HA HA HA

 

[ats5g]

Spanky,

Can you provide any generalizeable evidence for this assertion (i.e. not just specific anecdotes where this was the case)? I'd be inclined to add "or may not." Thanks.

Rich,

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

If you wanted to mirror the active fund holding some cash, you could always hold the index fund and a small % of a money market fund. I haven't seen much evidence of active funds moving to cash right at the right time before a bear market.

- Alec

 

[Rich_by_the_Bay]

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]

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]

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]

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).

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.