Index funds continue to grow

Allen Wisniewski

The largest mutual fund is now the Vanguard Total Stock Market Index fund.  This fund has now surpassed in size the PIMCO Total Return fund, which is a bond fund.

A total market stock fund essentially invests in the entire market of U.S. listed stocks.  Which means, the fund is comprised of large, medium, and small publicly traded companies.

Many of you are probably familiar with the S&P 500, which is an index of large companies.  A total market fund includes the S&P 500 plus the medium and smaller companies.  Approximately 80 percent of the value of a total market fund is comprised of S&P 500 companies.  The funds are weighted by market capitalization, which is why large stocks will tend to dominate the performance.

The comparison I offered between the Vanguard and the PIMCO funds might not adequately explain the growth of indexing.  Some of the shift might just be the public moving money from stocks to bonds without considering the merits of index products.

A better comparison would be to show how index products have grown over time. In the year 2000 9 percent of funds were indexed, and now that figure has grown to 28 percent. This clearly shows that index products are becoming increasingly more popular.

Lower fees are the main reason for the attractiveness of index funds.  The differential in fees is quite large.  While fees will vary by the type of product and the amount invested, the typical cost of an index product would be .1 percent, and one with active management is around 1.0 percent.

Someone might think that 1 percent still doesn’t sound like too much to pay.  That 1 percent is a per year charge on the assets under management, not on the returns.  If your fund returned 10 percent for the year, the fees would amount to 10 percent of the return.  If your return was 5 percent, the fees would be 20 percent, or 10 times as much as the index product.

Over time a 1 percent differential in returns per year can become quite large.  If someone starts with $10,000 and it grows 8 percent per year, at the end of 20 years that person will have $46,600.  However, with a 7 percent return that $10,000 will only grow to $38,700.   This shows the power of compounding, in that a relatively minor cost of 1 percent of $10,000 or $100 will result in a cost of nearly $8,000 over 20 years.

A person might expect with the higher expenses for active management they would get something in return.  While the fund manager has higher costs in terms of researching more companies, on average there does not tend to be any benefit in added returns.

Obviously there will be some active managers who outperform, but very few will be able to do so consistently over long periods of time. The likelihood of superior performance with active management is better among smaller companies, where the market is less efficient versus large corporations.

This should not necessarily imply that an investment advisor is of no use.  For someone whose knowledge of investing is limited, an advisor can help with portfolio construction and match appropriate investments for someone’s risk tolerance and time horizon.  However, an investor should know how their advisor is being compensated, and stay away from products where the advisor is getting a large commission.

There are many index products, which someone can invest in.  Investing in a total return fund is attractive for many investors, since you can have exposure to the entire U.S. market with just one fund.  I would also recommend that someone have an international fund to go along with the total market fund.

Someone could get very similar performance investing with an S&P 500 fund.  The S&P 500 fund would be slightly more conservative than the total market fund, since it doesn’t have the smaller companies.  A person, who is more attuned to the market, might have an S&P 500 index fund along with separate small and medium capitalization funds, which could be actively managed.