Q&A: The Pros and Cons of Index Funds

Q: Hi, Mary Ellen,
I just finished a book by John Bogle who made the extreme argument for Index funds. You certainly mentioned them favorably in class, but I didn't get the impression they should necessarily be the cornerstone of a portfolio. What percentage of a portfolio do you think it makes sense to have in index funds? — Jo

A: Hi, Jo,
There are pros and cons to index funds, just as with any investment. John Bogle, the pioneering founder of Vanguard Group, makes a strong case that the simplicity and cost savings that can be derived from index fund investing make this the strategy of choice. But there are (naturally), other opinions. An eloquent counter argument is made by Vern C. Hayden, a veteran financial planner. He contends that while it’s nearly impossible for most active managers to beat the index on an annual basis, beating an index is simply the wrong way to think about fund manager performance. More essential (and more possible) is to find managers and strategies that ensure that one does not lose money. “Indexing may work in up markets, but it’s a disaster in down markets.”

The Benefits of Index Funds

I think John Bogle is right in many ways and his Little Book of Common Sense Investing is a good introduction to the benefits of index investing. (You can get a taste of Bogle’s approach in this op-ed that ran in the Wall Street Journal in March of 2006.) In it he makes a strong case that the “bewildering array of choices among nearly 5,000 equity funds has ill served investors. The returns incurred by the average equity fund investor since 1984 have averaged just 2.7% per year, a shocking shortfall to the 9.3% return earned by the average fund. The result is that the average fund investor has earned less than one-quarter of the stock market’s 12.2% annual return.

“Investors seem largely unaware of the substantial gap by which stock, bond and money market funds lag the returns of the markets in which they invest. While the Standard and Poor’s 500 Stock Index has risen at a 12.2% average annual rate since 1984, for example, the average equity fund has grown at a 9.3% rate, only three-quarters of the stock market’s return. Bond funds have earned only a slightly higher fraction of bond market returns. And yields of money-market funds are less than one-half of the current yield on short-term investments.

What accounts for these shortfalls? They are largely created by the costs incurred by mutual funds. How could it possibly be otherwise? With expert professional investors dominating the financial markets, as a group they must earn the market return before costs (a zero-sum game) and fall short of the market by the amount of the same costs they incur in the futile effort to gain an edge (a loser’s game).”

The Down Side of Indexing

An eloquent counter argument is made by Vern C. Hayden, a veteran financial planner with 20 years experience. He contends that while it’s nearly impossible for most active managers to beat the index on an annual basis, beating an index is simply the wrong way to think about fund manager performance. More essential (and more possible) is to find managers and strategies that ensure that one does not lose money. “Indexing may work in up markets, but it’s a disaster in down markets. The underlying assumption that the investment objective is to beat the market is a premise that defies legitimacy. It’s imperative for us to distance ourselves from the indexing theory in order to create portfolios for clients that will not result in sending them into catastrophic poverty…. The first rule in managing money is not to lose money.”

Hayden stresses that one can find portfolio managers with solid records of avoiding losses. He also points out how important it is to structure portfolios with a mix of assets (stocks, bonds, commodities, cash)—again as a way of preventing the catastrophic losses that can hit those investors who just buy a stock index fund. To read more on Hayden’s approach to financial planning, check out his new book, Getting An Investing Game Plan.

Not All Index Funds Are Created Equal

In addition, there can be serious problems with “index funds”; just because something is called an “index fund” doesn’t mean it’s cheap, tax efficient, or even a halfway-decent investment choice. As Bogle discusses in The Little Book of Common Sense Investing, broad index funds based on indexes like the S&P 500 are useful ways to invest in a large slice of the stock market, but the financial services industry has been busily subverting the whole concept, creating indexes that track narrow and often quite arbitrary and risky slices of the market, such as “green energy stocks.” Funds based on these dreadful pseudo indexes have no place in a sane person’s portfolio. Further, very narrow index mutual funds and exchange traded funds often have high expense ratios and high turnover, eliminating the two biggest advantages of index fund investing.

Avoid “One Size Fits All”

How much indexing is enough? It really depends on the person and their portfolio. For example, a young woman who works at IBM recently just set up her first 401k. IBM has a fabulous plan and their core “Tier One” investment options include an array of super-cheap, very broad index funds from Vanguard. Her 401k is invested in a broad total US stock market index fund, a comparably wide-ranging international index fund (including emerging market stocks), and a total US bond market index fund. She's also started building an emergency cash reserve. She’s definitely on the right track since she’s getting the benefits of low costs (as advocated by Bogle), but is also diversified well beyond just the large US stocks that make up the S&P 500 index (as stressed by Hayden). Eventually as her assets grow she could add a couple more specialized funds that are actively managed (an option that her IBM plan gives her). She might well look, as Hayden suggests, for managers who may not always beat their “benchmark indexes” but who instead aim for consistent, positive returns in both up markets and down markets. But for now, there’s much to be said for her simple approach and since she is in her 20s the index fund strategy is particularly powerful as the savings she will realize by keeping her costs low will compound dramatically over 40–60+ years of investing.

Older investors with substantial investments are another case altogether. It makes no sense to dismantle something good just to buy index funds. Investors who have well structured portfolios of individual blue chip stocks and bonds, or excellent selections of reasonably priced actively managed funds should, as Hayden argues, be very cautious about shifting to an index-fund strategy. The costs of mid-stream shifts in strategy can be very high: taxes, commissions, other transaction costs, timing errors can all easily wipe out any hoped-for cost-savings associated with indexing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.