Many of you have suggested I just go away entirely and get Dick to write this column. He liked this idea until I told him about the pay. ‘What would I do with that much money?’ he asked. ‘Put it in index funds?’ I asked back.Which brings us to #19 of his 35 . . .

Item 19: Index Funds

Statistics show that generally speaking, it is difficult to pick a stock or a fund that will do better than the over-all market year after year. Some do it sometimes, but few do it all the time. The odds are against it. The most popular proxy for the over-all market are funds that track the S&P 500 Index. Vanguard, the largest such fund, has outperformed the average general equity fund by an average of 14% over the past 25 years. This furnishes ironclad evidence that it is better to own the broad market than to pick an active manager at random. And if you check out track records and do your homework, you still probably need some luck to select a market-beating stock or stock fund. Why rely on luck when there is a sure fire alternative? True, you give up all chance of beating the market, but you will fare better than most investors. In any given year, of course, an actively managed fund may do far better than the market, but the question is will the winning fund keep on winning? Most revert to mediocrity. Meanwhile, index funds plod along, out-performing actively managed funds in most years. That consistently good performance eventually leads to excellent long-run results, due, in part, to their low expenses and tax efficiency.

In addition to index funds that track the over-all-market, there are those that track the Dow, the Nasdaq 100, and individual industries. There are also ETFs or electronically traded funds that trade like stocks on the American Stock Exchange. Most popular are ticker symbols ‘SPY’, known as ‘spiders’ which give you in one stock the entire S&P 500 Index; ticker symbol ‘QQQ’ or Qubes, which give you all 100 companies in the Nasdaq 100 Index, and ‘DIA’ known as diamonds, with each share giving you ownership in all 30 blue-chip stocks of the Dow Jones Industrial Average. On the American Exchange you can also buy a stock that represents an entire industry. ‘IYH’, for example, represents the health care sector.

One of the knocks against index funds is this: If the big gains of the ’90s are not going to be repeated anytime soon and if Warren Buffet is right in his forecast of modest 7 to 8% gains, on average, over the next decade, then the attempt to do better than the over-all market via actively managed money may make more sense. There will always be a place for index funds but, at least for a while, they may have peaked in popularity.

☞ They may have peaked in popularity – I won’t attempt to predict that – but they certainly will not have come to the end of their winning streak relative to the competition. There’s just no way that all but a tiny fraction of actively managed funds will beat broad index funds – and that sought-after elite fraction is readily identifiable only with hindsight. The index funds have 20-pound jockeys (or should: if you have a domestic US index fund charging more than 20 hundredths of one-percent in annual expenses, it is charging too much). The actively managed funds, by contrast, typically have 100- or 200-pound jockeys, when you add up their annual expenses and factor in their sales fees and the drag of the transaction costs they must overcome (namely, the costs of buying and selling individual stocks rather than just buying and holding). Add in the effect of taxes, if your mutual fund shares are to be held outside the shelter of a retirement plan, and the actively managed fund becomes a horse straining under the weight of two or three men. How fast could you run under those conditions?

 

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