OT: financial whizkids, talk to me about index funds

[Climb01742]

i've read this before...that after accounting for expenses, index funds beat managed funds. an article from today's nytimes about a study by MIT prof puts forth the argument again:

http://www.nytimes.com/2009/02/22/your-money/stocks-and-bonds/22stra.html?ref=business

curious what our resident financial brain trust thinks. thank you in advance.

[dekindy]

Any sound strategy consistently applied over long periods of time will accomplish your goals, assuming you select a good organization to invest your hard earned dollars. Do you need help implementing this is the question?

If you don't need help go with the cheapest option available because expenses are for certain and superior management is not. OTOH even if an active management does not "outperform", whatever that means, a good manager can greatly reduce portfolio volatility. Since volatility is the main investing reason that investors lose money or significantly underperform the market, it is a significant consideration.

The bottom line is not to get caught up in all the noise and select the invest methodology and guidance that is appropriate for you to be a successful investor. Do what ever it takes to get your personal return as close to market returns as possible. Your return, no matter how achieved or at what cost, is all that matters. If your personal return is anywhere close to the market, then you have probably beaten 99% of investors. It is the dying truth.

[1centaur]

While the professor helped his case by his tax assumptions and his 20-year view, the arithmetic is what it is. Actively managed funds have the inherent disadvantage of tending to grow after periods of outperformance while index funds do not. That's because investors (and their brokers) often follow recent performance as a guide to future performance. To the extent that investing styles tend to run hot and cold over cycles, putting more money in after someone has done well is a recipe for dollar cost averaging in reverse: more money being used to chase fewer attractive opportunities, thus pulling down returns over time. Throw in expenses and taxes and changing managers over 20 years and you have a recipe for mediocre averages dragged down below index returns by expenses and taxes.

I would advise people to view an actively managed fund as they would a stock. That might not be intuitive, but it's a good tip. Each manager really does have his/her style and strengths, and if you analyze those you can invest at a good time and get out at a good time. Those strengths become evident over time - 5-7 years let's say. How is the manager in hot markets vs. cold markets? Up market alpha generator or down market alpha generator - few managers are both. 25-year-olds running big cap value for a major fund complex most likely have not shown what they are. View actively managed funds as things you are willing to time and you can beat the index if you do your homework right. If you just want exposure to a segment of (or the whole) market you can try ETFs, though I dislike the K-1s in March delaying my taxes and in smaller sectors the overweighted effect of a name or two (if you don't know what I mean, don't invest in ETFs).

Hedge funds are a whole 'nother thing. By definition, extreme manager skill is rare, but these days hedge funds are not. Don't assume genius because someone has a hedge fund or has successful investors (as Madoff did). Understand really well what a manager is doing to create returns or don't invest. Some hedge funds had strongly positive returns in 2008 due to actually being hedge funds, not just risk takers. It could take years for an index fund to catch up to that even if the hedge funds return zero for years.

Speaking of years, that's the crux of the professor's argument. Focusing on aggregate numbers over a very long period is a way of tilting the playing field in his direction. Don't invest in anything but index funds if you really plan to invest for 20 years in one thing (and I'm not saying an index fund will be a great 20-year investment; as I have said here before the American century is over. A 20-year investment in a China index fund makes more sense to me now than the US equivalent, and I might still prefer an actively managed China fund). Whether buying a stock or a fund, every dog has its day and then it's time to move on. You cannot be passive with your investments or they will revert to the mean or worse. Cull, prune, re-examine and lose your emotion. If you are not going to do that, index funds may be your best hope, and diversify away from the US and into fixed income for part of your portfolio no matter what your age; JMO.

[Karin Kirk]

Great post Centaur, thanks!
I just moved some of our funds away from a financial adviser because he wasn't coming close to the index funds and we were paying for his services to boot. I've always been a fan of the index funds, but I am having fun with individual stocks too. So for now I'm a DIY investor. I can easily see how people get addicted to this; it sure is interesting.

[Louis]

Check out the total returns on the various Vanguard index funds. Just about the lowest expense ratios out there.

Disclaimer: I do not work for them.

[Joe Cyclist]

The author made some good points, but better points were brought up by dekindy and 1centaur. What you invest in is actually less important than how you invest. It's important that you have an overall strategy based on the type of investor you are.

"Index funds" is not an asset class, but just a way to implement your strategy. For very efficient markets like large cap equity or US Treasuries, index funds can make a lot of sense.

But for illiquid markets, a good manager will make all the difference.

There is a downside to index funds which may sound silly, but it's true: Index funds are boring. If you invest in index funds, you will never be able to brag that you kicked the market's butt or that the stock you bought returned a bazillion percent in just a month. It just won't happen with index funds. The opportunity to beat the market is important to some investors.

[WadePatton]

Some good points above.

But I must reveal my total package financial adviser. His plan is extraordinarily simple and logical and covers every thing from debt to insurance and investing. While the plan is simple and effective, it is more work than most folks will put forth.

http://www.daveramsey.com/ -- cash is king and debt is dumb.

[robin3mj]

Roughly 70% of a portfolio’s performance can be explained by asset class allocation, so any discussion of index fund vs. actively managed is really only confined to the remaining 30%. (Note: this view is held by David Swensen, who manages the Yale endowment, as well as numerous other advisors and scholars of large portfolios, pensions, and endowments.)

The lower fee loads and stability of an index fund are extremely tough to beat. Over a long time horizon, almost no one will beat the market consistently, and those that do are often the lucky beneficiaries of survivor bias, meaning that they may have outperformed for 10 years, but that is because their number is almost up. This is the very definition of “past performance does not guarantee future results.” If an manager boasts about their returns vs. an index for the past X years, as they often do in their ads and prospectus, take a look at the latest X+5, X-3, etc. years to make sure they aren’t just cherry picking the highlights.

The bottom line is that if you know your necessary time horizon and your personal risk profile, your best bet is to choose your asset classes wisely, and then let them ride with the indices.

+1 on Vanguard.

[marle]

http://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street

The above url gives a brief over view of a book well worth reading.