Understanding Index Funds & The Importance of Costs

As I noted in my previous post, I want to continue to focus on areas that I think are important in the context of financial planning for the new year. As such, today I wanted to focus on index funds and the importance of costs. I originally envisioned taking a much deeper dive into both of these topics since they can be a key factor in building wealth and achieving financial independence. I still plan to do so in the future so consider today’s post as simply an introduction to both.

Who was Jack Bogle?

The man above is John (Jack) Bogle (May 1929 – January 2019). Jack Bogle is considered the father of the index fund. In addition to pioneering the index fund, he founded Vanguard in 1975 which is now the world’s largest mutual fund organization and a favorite of many investors in the pursuit of financial independence and/or FIRE. Warren Buffett noted the following about Jack Bogle in his annual letter to Berkshire Hathaway Inc. shareholders in 2016:

“…If a statue is ever erected to honor the person who has done the most for American investors, the hands- down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value. In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.” [1]

Jack Bogle revolutionized the investing landscape and is a key reason that so many are able to leverage the financial markets to build wealth in the manner we do today. He published many great books on investing including The Little Book of Common Sense Investing, which many consider be to an investing bible. This book is a great read for anyone seeking to achieve financial independence through index fund investing.

What is an Index Fund?

So what is an index fund? An index fund is a type of mutual fund or exchange-traded-fund (ETF) that seeks to track the underlying index. By seeking to track the underlying index, the fund seeks to match the performance (i.e. return) of the index the fund seeks to track. For this reason, the intent of an index fund is not to “beat the market” but instead to “be the market”. Index funds allow the average investor to achieve higher returns but at lower costs than actively managed investment alternatives.

What Index Funds Are Available?

Common indices  that you see include the S&P 500, Nasdaq, and Dow Jones Industrial Average. However, there are indexes and subsequently index funds for most markets in the world. There are also index funds that are designed to track the entire market. Many in the financial independence community seek to invest in low cost, broadly diversified index funds that track the S&P 500, total stock market, total bond market or some segment of each. Below are common examples of index funds tracking these three markets that you will see discussed in financial independence oriented articles, blogs, and books. There is a reason. They are largely low cost and broadly diversified.

Index Funds Tracking S&P 500

Index Funds Tracking Total US Stock Market

Vanguard Total Stock Market Index (VTSAX)

Fidelity Total Market Index Fund (FSKAX)

Schwab Total Stock Market Index (SWTSX)

Wilshire 5000 Index Investment Fund (WFIVX)

iShares Russell 3000 ETF (IWV)

Index Funds Tracking Total Bond Market

Vanguard Total Bond Market Index (VBMFX and VBTLX)

Vanguard Total Bond Market ETF (BND)

Fidelity Total Bond Fund (FTBFX)

iShares Core U.S. Aggregate Bond ETF (AGG)

The funds above are only examples for the market segments noted. There are many other index funds available including those tracking indices in other countries as well as those tracking indices representing more specific segments of the market (i.e. small cap, mid cap, value, growth, industry specific, etc.). According to a Bloomberg article from January 2019, there are more than 3.7 million indices that exist. [2] Although many do not have a fund tracking them, this just gives you an idea of the number of indices that are in existence.

What Are the Advantages of an Index Fund?

As noted at the onset of the post, index funds seek to mimic the performance of the underlying index they track. As a result, the funds do not seek to outperform the underlying index (otherwise known as investment alpha). This offers several advantages:

1. Lower Costs: Index funds often have lower costs since they do not require active management (i.e. frequent buying and selling in order to outperform the market) resulting in increased transaction costs. As you will see below, lower cost is key.

2. Greater Tax Efficiency: Index funds are inherently more tax efficient because there is less portfolio turn-over since, once again, the funds do not require active management. Active management requires that the fund manager actively trade in and out of the market as necessary to attempt to outperform the corresponding index. Since index funds are designed to passively track the underlying index, there is a greater tax efficiency.

3. Greater Diversification: Since index funds are designed to track the underlying index, they are often more broadly diversified that other investment alternatives. Diversification ultimately reduces risk. As the old saying goes, you don’t want all of your eggs in one basket. The same can be said for investing especially for those seeking to invest for the long-term.

It is important to note that not all index funds are low cost, tax efficient, and diversified. Because of sheer number of indices and the ability to build hybrid financial instruments, you can have “index funds” that are designed to track an underlying index, but they may also have an active management component. You can also have situations where an index fund may be available to you in a workplace 401K, 403B, 457, etc. but the administrator may charge higher fees than if you were to invest in the fund directly with the broker.

The Importance of Costs

I am sure I will have many more posts on the importance and impact of costs because this is one of the more important aspects of successful long-term investing and wealth building. As an investor, there are only a certain number of variables in your control. Costs are one of them. Costs can have a significant impact on your ability to build wealth. According to a Forbes article from October 2020, the average actively managed equity fund had an expense ratio of .74%. The average equity index fund had an expense ratio of .07%. [3] For context, the go-to index fund of many in the financial independence community is Vanguard’s Total Stock Market Index Fund (VTSAX). This index funds has an expense ratio of .04%. This represents a difference of .70% when compared to the average expense ratio of actively managed funds. You might be thinking .70% is really not that bad. Let’s look a few examples to put some numbers to it to see.

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Example # 1 ($0 Invested Initially, $50K Invested Annually in Actively Managed Funds):

Your starting investments are $0. You invest $50,000 each year in actively managed funds with an average expense ratio of .74%. Assuming an 8% return, the following would be the result after 30 years:

Initial Balance: $0

Annual Contributions: $50,000

Gross Ending Balance (Excluding Fees): $6,117,293.40

Net Ending Balance (Less Fees): $5,309,199.69

Total Cost of Fees: $808,093.71

In this example, choosing to invest in actively managed funds ends up costing you ~ $800,000 in fees over 30 years.

Example # 2 ($0 Invested Initially, $50K Invested Annually in Index Funds):

Your starting investments are $0. You invest $50,000 each year in index funds with an average expense ratio of .07%. Assuming the same 8% return, the following would be the result after 30 years:

Initial Balance: $0

Annual Contributions: $50,000

Gross Ending Balance (Excluding Fees): $6,117,293.40

Net Ending Balance (Less Fees): $6,035,384.29

Total Cost of Fees: $81,909.11

In this example, choosing to invest in index funds ends up costing you ~ $82,000 in fees over 30 years. That a difference of over $700,000 when compared to the actively managed alternative.

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In the examples above, I assumed a $0 initial balance and $50,000 annual contribution. I want to provide a different example to further highlight the importance of costs. What if you already have a starting investment balance of $1MM? Maybe you inherited it. Maybe you have slowly built up your portfolio over time on your journey to financial independence. Let’s take a look at costs in this scenario.

Example # 3 ($1MM Invested Initially in Actively Managed Funds, $0 Invested Annually):

Your starting investments are $1,000,000. You do not contribute any additional money annually. You choose to invest your initial balance in actively managed funds with an average expense ratio of .74%. Assuming an 8% return, the following would be the result after 30 years:

Initial Balance: $1,000,000

Annual Contributions: $0

Gross Ending Balance (Excluding Fees): $10,062,656.89

Net Ending Balance (Less Fees): $8,187,169.44

Total Cost of Fees: $1,875,487.45

In this example, choosing to invest in actively managed funds ends up costing you ~ $1.9MM in fees over 30 years. Ouch!

Example # 4 ($1MM Invested Initially in Index Funds, $0 Invested Annually):

Your starting investments are $1,000,000. You once again do not contribute any additional money annually. However, you choose to invest your initial balance in index funds with an average expense ratio of .07%. Assuming an 8% return, the following would be the result after 30 years:

Initial Balance: $1,000,000

Annual Contributions: $0

Gross Ending Balance (Excluding Fees): $10,062,656.89

Net Ending Balance (Less Fees): $9,868,821.91

Total Cost of Fees: $193,834.98

In this example, choosing to invest in index funds ends up costing you ~ $190,000 in fees over 30 years. That is a difference of $1,681,652.47 when compared to the actively managed alternative. That is ~ $1.7MM of your wealth that you will never see.

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Do I have your attention yet? You may be asking yourself at this point… is that math right Henry? It sure is. You can run the calculations yourself if you like. Here is a quick tool that can utilize if you are not a fan of Excel. 

The difference between investing in actively managed funds vs. passively managed (index) funds can have a big impact on your ability to build wealth as well as keep it. Someone out there is probably thinking… Well, Henry, you are missing the point! Actively managed funds are designed to outperform the underlying index. That is what I am paying for! The investment alpha… I am sure I will come out ahead when you factor this in. If you think this it true, you are not alone. Fortunately, you are not alone in being wrong either.

What About the Investment Alpha?

Actively managed investments to include actively managed funds are exactly that… actively managed. What is the purpose of active management? It is simple really. The purpose is to outperform the underlying index. For example, if I invest in an actively managed large cap (think large companies) mutual fund or ETF, then I want to outperform the comparable index which would be the S&P 500. The same would be true for any other actively managed fund. The sole reason for investing in these products is to outperform the comparable index. You do not seek to “be the market”. Instead you seek to “beat the market.” Sounds good in theory.

The Truth About Active Management

One thing that you will discover as you venture further down the rabbit hole of financial independence and the FIRE movement is that there is a not so well kept secret.

No one can consistently predict what the stock market will do in the short-term and no one can consistently time and/or outperform the market.

I know what you are thinking. Slow down Henry… I am calling you out on this one… What about Warren Buffett? What about Peter Lynch? What about that guy in that movie played by Christian Bale who predicted the sub-prime mortgage crisis and made like a billion dollars? What about that guy?!?! What about my advisor…

Yes, it is true that there are some truly gifted investors (Warren Buffett being one), but the fact of the matter is the ability to consistently outperform the market over the long-term is near impossible. This is not hyperbole. It is fact supported by data. 

The SPIVA Scorecard is published semi-annually by the S&P Dow Jones Indices (DJI). It compares actively managed funds against their corresponding benchmarks. The latest scorecard updated through June 30, 2020 can be found here. There is a lot of data here for those interested, but there are a few key points I want to highlight for today’s post:

• 63.17% of large cap funds underperformed the S&P 500 index over one year. This figure increases to 77.97% over a five year period, 82.06% over a 10 year period, and 86.92% over a 15 year period.

• 67.40% of domestic equity funds underperformed the S&P 1500 composite index over one year. This figure once again increases to 80.09% over a five year period, 84.49% over a 10 year period, and 87.23% over a 15 year period.

The full SPIVA US Scorecard is an interesting read if you have the time. I would recommend you check out the U.S. Persistence Scorecard to get a better appreciation for how much luck vs. skill has to do with a funds performance. The conclusions are clear. It is difficult if not impossible to outperform the corresponding market index especially when measured over long periods of time. 

What About Buffett?

Despite the odds not being in your favor, what if you could find that one diamond in the rough? What if your advisor is the one? What about Warren Buffett? 

Since the average person has heard of Warren Buffet and he is widely regarded as maybe the most brilliant investor of all time, lets look at a few of his quotes concerning index funds. [4]

“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” – Warren Buffett in 1993

“The 21st century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners — neither he nor his ‘helpers’ can do that — but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” – Warren Buffett in 2013

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.” – Warren Buffett in 2014

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.” – Warren Buffett in 2016

What more do you need than arguably the greatest investor of all time consistently delivering the message that the vast majority of investors (to include the HENRYs of the world) should invest in low cost, broadly diversified index funds? If the Oracle of Omaha isn’t enough for you, there are lots of studies and lots of books available on the subject. A couple of my favorites include:

• The Simple Path to Wealth by JL Collins, 
• A Random Walk Down WallStreet by Burton Malkiel
• What Wall Street Doesn’t Want You to Know: How You Can Build Real Wealth Investing in Index Funds by Larry Swedroe
• The Wall Street Self-defense Manual: A Consumer’s Guide to Intelligent Investing by Henry Blodget

Also for those interested, I included an excerpt from Warren Buffet’s annual letter to Berkshire Hathaway Inc. shareholders in 2013 at the end of the article. [6] This letter tells you everything you need to know about Buffet’s opinion.

Are You Getting Robbed & Don’t Know It?

Perhaps you were wondering why the article started with a picture of money growing on a tree. After all, we all know money doesn’t grow on trees. Right? Well, if you have a financial advisor, you may be the money growing on their tree and not even know it. Sorry to be the bearer of bad news, but I started this blog to educate, and understanding investment costs are a key part of it.

In addition to the underlying costs of the funds you invest in, it is also important to consider what you pay your financial advisor if you have one. Remember the previous examples provided demonstrating the importance of costs driven solely by the fund’s expense ratio? What if you also factor in the fee your financial advisor charges on top of the actively managed mutual funds they may be investing you in? According to Investopedia, the average fee for a financial advisor’s services is 1.02% of assets under management (AUM) annually for an account of $1 million. [5] If you unfamiliar with an AUM fee it is quite simple. An individual or entity will manage your financial assets in exchange for a small percentage calculated from your total assets being managed. Doesn’t sound too bad, does it? Wrong! Let’s look at one of our previous examples and assume your costs are 1.76% in the aggregate (1.02% Advisor Fee & .74% Fund Fee).

Example # 5 ($1MM Initial Investment in Actively Managed Funds with AUM Fee):

Your starting investments are $1,000,000. You do not contribute any additional money annually. You choose to invest you money with a financial advisor charging a 1.02% AUM fee. The advisor invests you in actively managed funds with an average expense ratio of .74%. Assuming an 8% return, the following would be the result after 30 years:

Initial Balance: $1,000,000

Annual Contributions: $0

Gross Ending Balance (Excluding Fees): $10,062,656.89

Net Ending Balance (Less Fees): $6,146,697.79

Total Cost of Fees: $3,915,959.10

So what did you get for ~ $4M over 30 years? 

Did your financial advisor outperform the overall market or the comparable index funds corresponding to your underlying investments? Probably not…

Did you pay more taxes and/or incur additional costs and fees as a result of your financial advisor buying and selling in an effort to actively manage your portfolio and outperform the market? Probably…

Do you get your investment alpha and was the net result worth it when factoring in the 1.02% AUM fee and any additional costs? Doubt it…

Your decision to stick with a financial advisor charging an industry average AUM fee results in you giving up ~ 40% of your potential wealth over a 30 year period. That is $4,000,000 that you will never see. Costs matter. 1.02% matters. Most people don’t consider the long-term impact of an advisor syphoning off a small percentage each year. You lose the fee AND the growth opportunity of that fee over the long-term. Despite efforts to make you think the contrary, your financial advisor is NOT your friend. If you are not careful, they will rob you of your wealth 1% at a time and you will never know it. Educate yourself and ensure you are getting a true return on what you are paying for. If you are paying an AUM fee with a traditional brokerage firm, you probably are not. A couple of meetings a year, sub-par returns, and a Christmas card aren’t worth it. You can do better.

Note: In the examples above, I don’t take into account additional fees often associated with actively managed investments including sales fees, commissions, redemption fees, trading fees, 12(b)1 fees (fancy for service or marketing fee), front-end load fees, back-end load fees, etc.) All of these fees eat into your ability to build and grow long-term wealth. I also did not present an example whereby your financial advisor is charging you an AUM fee but investing you in index funds. Why in the world would a financial advisor do that you may ask? Isn’t the active management what you pay them for so that you may be the lucky one to outperform the market? There is another dirty little secret the financial services industry doesn’t want you to know. Some financial advisors will sell you on high cost, actively managed funds while investing their own money in low cost index funds. Some financial advisors at least have decency and wherewithal to invest you in primarily index funds because they know they cannot outperform the index. Either scenario should be avoided. Understand the fees you pay. Understand what you are invested in. Understand what value your financial advisor is adding or not adding. Knowledge is power.

It’s Really Not That Complicated

The unfortunate reality is that the financial services industry wants you to think that managing your investments is complicated. In reality it is not if you are a long-term index fund investor. Once you discover the truth that you can’t consistently outperform the market over the long-term, investing becomes much less complicated. You don’t need to analyze financial statements. You don’t need to pick stocks. You don’t need to take advantage of fancy financial instruments or day-trade to become wealthy. You simply need to invest in low cost, broadly diversified index funds based upon your desired asset allocation which is dictated by your goals, risk tolerance, and risk capacity. It doesn’t matter if you have $100,000 or $10,000,000. The fundamentals are the same.

Conclusion

Many are not comfortable in managing their own investments because they are needing to grow their investing acumen first. Even armed with the knowledge necessary to do so, some will never be comfortable in managing their own investments. That is not a bad thing. There is nothing inherently wrong with paying someone else to manage your investments. The purpose of today’s post is not to persuade you to manage your own investments. The purpose of today’s post is to ensure you have a better understanding of index funds, active vs. passive management, and why costs matter. There are many things outside your sphere of control when it comes to investing. Costs are not one of them. Knowledge is power.

Regards,

Henry

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Henry’s Take:

If you couldn’t tell from the post, I like many in the financial independence blogosphere, am a fan of index funds for the reasons noted and many others. I suspect you will be as well if you are not already. I have included the index funds I am currently invested in below in case you are curious.

As you can see, nothing extravagant. It is important to note I am a fan of simplicity. I prefer to have 3 or 4 funds in total. The variability in the funds below is driven by the investment options available in our various retirement accounts as well as taxable brokerages.

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Excerpt from Warren Buffet’s Annual Letter to Berkshire Hathaway Inc. Shareholders in 2013 – Full Letter Available Here

When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions.

It’s vital, however, that we recognize the perimeter of our “circle of competence” and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.

Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.

I have good news for these non-professionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

That’s the “what” of investing for the non-professional. The “when” is also important. The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long- term results than the knowledgeable professional who is blind to even a single weakness.

If “investors” frenetically bought and sold farmland to each other, neither the yields nor prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.

Nevertheless, both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

References:

[1] https://www.berkshirehathaway.com/letters/2016ltr.pdf

[2] https://www.bloomberg.com/news/articles/2019-01-24/index-funds-are-king-but-some-indexers-are-passive-aggressive

[3] https://www.forbes.com/advisor/investing/etf-vs-index-fund/

[4] https://www.marketwatch.com/story/the-5-times-warren-buffett-talked-about-index-fund-investing-2017-04-28

[5] https://www.investopedia.com/articles/personal-finance/071415/how-cut-financial-advisor-expenses.asp

[6] https://www.berkshirehathaway.com/letters/2013ltr.pdf

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