The Benefits of Index investing
We love index investing because it minimizes investment costs and tracks close to well-defined benchmarks. There are several additional reasons we have made index funds the core of our Empathy, Evidence & Equations approach.
The most recent SPIVA US Scorecard from S&P Global reported that 75% of actively managed US equity funds underperformed their relevant benchmarks (aka indexes) in 2023.* On a risk-adjusted basis, 95% of actively managed US equity funds underperformed their benchmarks over the 10-year period ending in 2023. This basic pattern has been true for decades.†
Moreover, there is little consistency in which actively managed funds perform well. A Vanguard study reviewed actively managed funds that had performed in the top 20% for a 5-year period.‡ The vast majority of those funds did not maintain their position in the top 20% for the next 5-year period—81.7% fell to a lower performance category.
We frankly do not understand why anyone would choose to invest in actively managed funds with results like these when there is a superior alternative: invest in index funds, and have high confidence that you will achieve results very close to the performance of the index, which 95% of actively managed funds fail to do.
*Source: “SPIVA® U.S. Scorecard, Year-End 2023,” S&P Global, 2024.
†Source: “The Arithmetic of Active Management,” Financial Analysts Journal, William F. Sharpe, 1991.
‡Source: “The case for low-cost index fund investing,” Vanguard Research, May 2022.
For investments in taxable accounts, indexing provides the additional advantage of tax efficiency.
The typical actively managed portfolio turns over (sells) 50-100% of its holdings each year. A commonly cited average turnover figure for active funds is 63% with averages ranging from 70-91% depending on the fund.* That means investors in actively managed funds end up paying short-term capital gains or long-term capital gains on a large portion of their investments each year.
With index funds, the portfolio changes only when the index itself changes—for example, when a new stock is added to the S&P 500 or removed. Indexes change relatively infrequently, and the changes affect only small portions of the index composition, so index funds have low turnover. Vanguard’s S&P 500 index fund has a turnover ratio of 2.1%. Index funds are not tax-deferred investments per se, but, because only very small portions of the fund are turned over each year, only very small portions of the gains are taxable each year. The vast majority of gains in index funds are reinvested and grow tax-deferred until the funds are sold.
Russell Investments summarized the tax drag of actively managed funds like this: the average tax drag on large cap funds was 1.77%, on small cap funds was 1.78%, and on fixed income funds was 1.29%.†
*Sources: “Turnover ratios and fund quality,” Investopedia, retrieved 1/24/2024; “US Mutual Fund Turnover and Returns, 1991-2020,” Gene Hochachka, SSRN, December 10, 2021.
†Source: “What is the tax-cost ratio and why does it matter?” Ryan Pogodzinski, November 22, 2022, Russell Investments Blog, retrieved 1/24/2024.
Investors sometimes believe funds that charge higher fees will provide higher gains, but that is not usually the case. Studies by Vanguard, Morningstar, and other companies have found that the single factor that best predicts a fund’s performance is its expense ratio, meaning, the lower the expense ratio, the more likely the fund is to perform well.*
The average actively-managed fund’s expense ratio is about 0.59%, whereas the index funds we use have expense ratios of about 0.05%–0.15%.† These differences might seem small, but they compound and become significant over time.
*Source: “The case for low-cost index fund investing,” Vanguard research, May 2022.
† Source: “2022 U.S. Fund Fee Study,” Morningstar Manager Research, August 2023.
Our investment strategy is based on using historical performance data to predict how funds—and more important, specific combinations of funds—will perform over time. Every fund’s performance will vary over time, of course, but, because index funds are based on indexes, their investment philosophies will stay consistent.
That same analysis does not apply to actively managed funds. Those funds’ investment philosophies can vary over time, or a fund’s managers can diverge from their stated philosophy. For example, a fund that claims it is outperforming the market in large company stocks might actually be achieving its outperformance by investing in small company stocks. A 2024 study by S&P Global reported that fewer than half of all US equity funds maintained the same style over the 10-year period ending in 2023.* This style drift creates problems for modeling the performance of actively managed funds over time, but with index funds the phenomenon is negligible.
*Source: “SPIVA® U.S. Scorecard, Year-End 2023,” S&P Global, 2024.
The most popular index funds aim to replicate performance of the S&P 500, which is an index that tracks the 500 largest companies in America. Collectively, the S&P 500 accounts for about 80% of the value of all the stock of all the companies in the U.S. When you invest in an S&P 500 index fund, you are literally betting that, over the long haul, the largest American companies will grow and be successful.
Similarly, if you buy an index fund that tracks “small cap” stocks (relatively small companies whose total stock value is between $300 million and $2 billion), you are betting that, over the long run, America is a place where small companies can thrive and grow.
With most index funds, you are betting on segments of American business—large companies, medium-sized companies, small companies, companies that are trying to grow, companies that manage their growth, and so on.
With actively managed funds (funds that do not track an index), you are making a more specific bet—you are betting on the capabilities of the fund managers who pick the stocks.
We strongly believe that betting on segments of American business is safer than betting on any one company’s fund managers or investment approach—which is one of the reasons we are bullish on index investing.
It’s also possible to buy index funds that are based on European indexes, emerging market indexes, specific parts of the US economy, and various kinds of bond indexes. Our strategy includes all of these too.
Our Core Strategy is to Add Value to Index Investing
We begin with index funds and then incrementally increase returns through strategic asset allocation, tax management, and minimizing other expenses.
When we find multiple ways to increase returns by small amounts, and then find multiple places to reduce expenses by small amounts, the long-term difference can be dramatic.
We believe that the most important investment decision you make is your asset allocation, meaning, how much are you investing in stocks vs. bonds, and how much specifically are you investing in different kinds of stocks—large cap, small cap, value, growth, sector funds, and so on. Your asset allocation will largely determine both how much return your investments will provide and how large the ups and downs will be along the way.
Past performance does not guarantee future performance, but historical data does provide an indication of how different asset classes will perform over time and how they are likely to interact. Our use of historical data allows us to construct a mathematically-based portfolio for you that is likely to be responsive to your particular investment needs.
Asset location refers to where you hold different kinds of assets. Should you hold growth stocks in an IRA and income stocks in a taxable account, or vice versa? A study by Vanguard found that allocating investments to the best locations could increase an investor’s effective returns by as much as 0.6%.*
Cookie cutter approaches do not work very well in this area because the best location for an asset depends on numerous factors that are unique to you: different types of assets you own, proportions of your assets in different tax categories, how far you are from retirement, your level of income, and so on. The subtleties of locating assets for your maximum benefit is part of why it is important to make investment plans based on your specific circumstances.
*Source: “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.” Vanguard, July 2022.
You’ve heard the adage to buy low and sell high. Many investors nonetheless buy high and sell low, in part because they don’t have a well-thought-out strategy for withdrawing living expenses. A study by Vanguard found a good withdrawal strategy could effectively add 1.2% to a client’s portfolio.*
*Source: “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.” Vanguard, July 2022.
The 2023 SPIVA U.S. Scorecard from S&P Global found that 95% of US equity funds underperformed their relevant benchmarks over a 10-year period.*
We believe that individual stocks and bonds should play a small role or no role at all in a research-based portfolio. If 95% of the full-time fund managers with MBAs from Wharton and PhDs from MIT can’t beat the relevant benchmarks when it’s their full-time job to do so, why does anyone else think they can?
We understand the desire to beat the market and the temptation that comes with that. We believe there is a place for “play money” in an investment portfolio to try to beat the market, as long as it’s clear that’s what it is.
*Source: SPIVA U.S. Scorecard Year-End 2023
Market timing decisions usually reduce total investor returns. A Vanguard study found that, over a 10-year period, investor returns averaged 0.81% less per year than the returns of the funds they invested in.* How can that be?
The answer is that many investors sell when prices are falling, and then later buy back in after prices start to rise again. They are practicing, “sell low, buy high.”
Our view is that if you want to access the high returns during market up cycles, the price you must pay is persevering through the down cycles. One key role an investment advisor provides is to support you and coach you through the down cycles, which are inevitable.
*Source: “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.” Vanguard, July 2022.
Typical advisor fees range from about 0.95%-2% on the first $1 million under advisor management, and then fees scale down slowly over the next $5-10 million.* A good advisor can increase your take-home returns by 1% or more, which pays for their fees. However, the work to manage $5 million is not very much higher than the work to manage $1 million, and most fee structures do not reflect that.
Rain Dog’s fees are optimized for investors with $1-$10 million in investment assets. We charge a base fee to cover our investment in research and technology, plus the baseline planning, management, and account maintenance work that we do for every client. Beyond that, our fees increase only slightly as assets under management increase. Check out our fee calculator.
*Source: “How Financial Planners Actually Do Financial Planning (2023),” The Kitces Report, Volume 1, 2023.
Each of these factors contributes a small amount to investor returns, and, collectively, they add up.
