What’s the Deal?
What is an index fund and how do they work? After reading this brilliant mini-publication on the subject you will be the one to ask at your next family party. First, lets understand what managers of other funds try to do, are paid to do, and why they can no longer do what we expect them to do.
Mutual fund managers try to generate a return for their investors which will make them happy, happy enough to stay with the company. They do this by providing a superior return, one the investor could not obtain on his own. The minimal goal of a fund is to exceed the average return of similar funds. For example Growth Fund A outperforms Growth Fund B on a consistent basis. Both invest similarly and have identical objectives and risk. Astute investor C will select Growth Fund A for investment simply because he expects to receive a better return for his money, $.
The manager of Growth Fund A is happy with his performance, the influx of new money, and the maintenance of the old. The fund directors are also pleased because the fund is profitable, has bragging rights over Fund B and is expected to attract new investors.
Lets interject a little logic here. How many investors brag about receiving average performance from their mutual fund? Few. How many mutual funds will use “consistently average performance” as a marketing slogan or an advertising strategy? Fewer still. We all want to be number 1. It is pretty tough attaining that #1 rating today since we now have over 9,000 mutual funds.
The reality of mutual fund investment of the 21ST century is that it is very difficult for any fund to consistently outperform its competitors. The reason for this is relatively simple. So many managers and management teams today have so much access to financial information at the press of a computer terminal button, that managers no longer can outperform based on crackerjack research. The information is common knowledge to those with access to information services and the internet, which is everyone.
Fund managers are getting younger and younger. At first I thought it was because I was getting older and older, but it isn’t. Maybe a little. Some major companies feel very comfortable hiring fund managers with little or no actual experience. Managers too young to remember Watergate or the Oil Embargo (ages of mid to late twenties and early thirties) are handling billions of dollars. Money handlers are getting younger and younger every year, and it makes sense. I heard one quoted the other day: "It's like, a totally phat investment, dude." I think that meant it was good.
The reason for these inexperienced money managers is simple. The powers that be don't really expect seasoned managers to make much of a difference anymore. Given the efficiency of the market and the magnitude of investment information, the great managers are being brought back to the pack. Any extraordinary wisdom is considered only a temporary or minor advantage not worth worrying about because that may be made up with a little luck. The young backwards baseball cap wearing, smart-phone texting, Prius driving money managers are not expected to have any unusual new age insight into the market. They need an ability to access information, keep pace with the investment crowd, and stay out of the court room for unsportsmanlike securities trading conduct.
If management does not make as much difference as in the past, why then do we see so many funds, particularly smaller in size, far outperforming the market? Glad you asked. Smaller funds particularly those only in existence for a few years sometimes make a big splash (or thud) early. We see advertisements of Little Fund G earned 62% last year or something close. Wouldn’t you want your money here? This occurs because when a fund is small, each security it holds represents a larger percentage of the whole. If some stocks in the portfolio do very well, this high relative representation increases the fund yield significantly assuming the other holdings are average and not bringing it down just as much. Naturally the fund marketers can bluster about this performance assuming we are uninformed and will believe this type of return can be maintained for an eternity. The intelligent investor knows better.
Smaller funds also tend to go in the opposite direction for the same reasons. Usually we don't see too much crowing about horrendous returns, they just wait until they get lucky and have something to boast about later.
A narrower focus in investment leads to more volatility. Smaller funds do not have the resources to diversify greatly simply because they have less money. Hence they focus on fewer areas. If they are lucky the returns can be excellent. If they’re not so lucky they have the potential to be regarded as the mutual fund dogs.
Management fees are the expenses which the fund incurs in order to operate the on an annual basis. These costs are usually around 1.25% for stock funds and about 1% or a little less for bond funds. These costs are necessary because of the research the management team must do on a daily basis to manage and to keep up with the other funds, to try to remain at least average.
When a fund outperforms a major index similar to its own holdings, it is doing very well. The advertising branch is more than happy to tell us how terrific the fund is for beating an unmanaged index. For example, if a growth & income stock fund (conservative growth fund) outperforms the Standard & Poor 500 Stock Index for a period of time, it will advertise this fact because it is an admirable return, and it is in the minority. Most funds do not outperform the index to which they are most closely related. Again the reason is that so much information is out there now that the markets themselves have become so efficient it is extremely tough. Add in the fact that the return is eroded by a percent or so (management fee), so the fund really has to outperform the index by more than you might think (see what that really means below) and it is even harder.
An index fund manager does not worry about beating other funds performance records. The goal of an index fund is to mimic the index as closely as possible. If the index is up 10%, the fund should be very close to that. Some index funds actually buy every stock included in the index, at the same percentage that the company is represented. This means that the only difference between the return of the index and the return of the index fund is represented by the fund management expenses. As with any business large or small, given the same income, if expenses are kept lower profit is naturally higher - Economics 101.
INDEX FUND OPERATION
Index fund expenses are extremely low. In many cases less than half that of managed funds, some even as low as 1-2/10% of assets (about 1/8 the average). The reason expenses are so low is that security selection is automatic. This reduction in cost translates directly to a greater return for the investor. Rather than a manager pouring over investment reports and internet information, most use an approach more closely related to a caretaker of a computer program. When this sophisticated programming indicates a change should be made the trade is executed. This is fairly rare because changes should be made only when the fund holdings don’t exactly represent the index. Sometimes a company is dropped or added to the index. The index fund then reacts and either sells or buys into that company to maintain the proper ratio of representation in the index fund.
Most managed funds try to sell when the stock has done well and buy into some when they believe they have a bargain. Naturally this is what we want and expect them to do. Transaction costs are incurred every time a stock is bought or sold, which is one of the reasons for the higher costs. Additionally, when stocks are sold for gains the fund shareholder must report his portion on his tax return for the year.
Index funds hold the same bushel of stocks year after year because the target index does not change very much. They buy only when a stock which should be represented in the fund isn’t. They sell when a stock has been dropped by the index itself. This is not an occurrence that happens regularly. Trading within an index fund, both buying and selling is rare. This means low transaction costs, and minimal annual capital gains.
Minimal capital gains does not mean minimal profits. The fund may grow in value without actually paying out capital gains to investors. For example, assume your fund holds XYZ Corporation stock. The company has done well, and tripled in value over the past two years. The mutual fund value increases an amount proportionate to the holdings of that stock. If the manager elects to sell the profitable stock within the portfolio and take the profit for the fund, the shareholders must declare that gain in the year the stock was sold, even though they still own the fund.
If the same situation occurs within an index fund, the value of the fund increases the same way. The difference is that the stock of the profitable company is not sold unless it no longer represents part of the target index, which is not very likely. The shareholders in this situation have more personal tax control. No capital gain tax liability is generated unless stocks within the find are sold, or they actually redeem the fund, which includes the gain the XYZ Corporation. Clearly the lack of a larger pay-out of capital gain does not mean a lack of gain, it means more control for the investor.
SIZE OF FUNDS
We already indicated a certain advantage of smaller funds, if you pick the right one. Disadvantages include higher expense ratios and the fact that a narrower focus increases risk. Larger managed funds (over 3 or 4 billion dollars) are a little more cumbersome than optimum size funds ($500 million to 3 Billion) because there are a finite number of shares out there to buy. We have to give some credit though to some very large funds who have managed to maintain superior performance. It is getting harder and harder to do.
The larger an index fund, the better. There we said it, we stand by it. The reason is simple. Lets assume we have a S&P 500 Index fund that has $20 million in assets. They try to represent the index and can do fairly well. Their expense ratio is likely to be greater than a larger fund because the operation is based on time at the computer and total profit motive more than trading, so the expenses may be 1/2 of 1 %.
It is also possible that the smaller fund may not be financially able to buy every company in exact proportion to their representation on the index. If they can, they will not get the bulk trading discounts a mammoth fund can get, further increasing expenses. When new money comes into the fund, they buy stocks, also without the huge discounts.
Contrast the small fund with a behemoth, for example a $50 billion dollar giant. Money comes in and instead of buying $25,000 of that and $50,000 of this to balance out, they buy a $2 million of this or $4 million of that. Instead of trying to hold say 300 of the 500 stocks in the index and hope they have a good representation, they have every one, in perfect representative proportion. Expense ratio of the smaller fund may be more than twice that of the Goliath.
The return of the smaller fund will probably be near the index, after all that is the idea. It may be higher or lower, within 1% or 2% or so, after subtracting internal costs. The big one should be within one or two tenths of a percent of the index. When the operational expenses are added, the fund should be within 1/4 or 1/2 of a percent of the actual index.
TYPES AND COMBINATIONS
All index funds generally have the same objective: To generate for the investor the same amount of return as the index on which it is based. There are many different indices.
There are small company (small cap) index funds, large company index funds (S&P 500) , foreign countries, and foreign regions (combined countries). There are U. S. and foreign bond indexes and a number of other combinations.
One reason for investing into different indices is that you will know you have no overlap of securities. Many funds buy the same stocks, but if the indices you choose do not contain any of the same companies, you will have a more diverse portfolio. For example, An investor may select a U. S. small cap index combined with a Pacific Rim (Japan, Hong Kong, Australia, Malaysia, Singapore, and New Zealand for example) for diversity. These funds will hold none of the same stocks. A bond index fund could be included without any overlap whatsoever.
It would not be so prudent to invest in index funds which cover similar areas. Choosing an S & P 500 index fund is fine idea for a conservative growth stock market investment. To combine a Wiltshire 5000 index fund with this would overlap. 500 of those same stocks would be represented within the S & P portfolio.
KOSO FUND - KIND OF, SORT OF INDEX FUND
Some index funds attempt to outperform the index. For example, they may try to emulate the index with 80% of the portfolio, but with the other 20% they have what would be termed a “manager’s discretion” portion. If we want the manager to have discretion, we should not be in an index fund. This type of index fund is tryng to outperform the market with the “descretion” part of the portfolio. A better way for we simple investors to accomplish this is to employ a true index fund with some of our investment dollars and select a managed fund with another amount of money.
With the KOSO Index Fund fund we have investment beurocratic mucki mucks trying to mess with a good thing. They want to be the leading performer of the index fund category. What nonsence. That is contrary to the objective of the idea. If the fund happens to outperform the index by a slight margin, the following year it probebly will underperform.
The reality is that the KOSO index fund will probably be very close in overall long term performance to the true index fund. Some years it will outperform, others it won’t. Why bother?
DO THE MATH
How good does an active manager have to be to outperform the index? Very good question again, we alluded to this earlier, now let’s guess at a close answer. First, we know that the markets are much more efficient than in the past so information is everywhere. A manager must sift out the bad and invest mostly in the good which for some reason other professional managers do not recognize. This is possible, and many will claim they can do it.
Assume that they are right and that some managers can consistently outperform their corresponding index. By how much do they have to better the mark to make the investment worthwhile? Again, suppose that all things are equal, except for the management fee which is (or should be) for an index fund much lower than your ordinary stock fund. The difference is about 1%.
A 1% difference means that the manager will have to outperform the index consistently by approximately 10% every year. Here’s why: If a fund returns 10%, and has a management fee of 1%, the investor’s net return is 9%, not ten. The difference between 9% and 10% is not 1%, but 11.1%. The difference of return (1%) is divided by the return itself (9%) the answer is 11%.
Here is an easier way of understanding this relationship. Suppose Fund A earns 30% this year and Fund B returns 15%. You would have to say the Fund A returned twice as much or 100% more, not 15% more than Fund B. So in order for the active manager to outperform the index, given the difference in management fees, the manager would have to consistently generate about 10% greater return than the unmanaged index - extremely tough in today’s complex market.
Investing into index funds does not ensure profitability. If the unmanaged index drops 25%, expect your fund to do the same. There is a good chance that many managed funds dropped 27% or more, but some may have gotten lucky and only lost 10%. This is obviously an advantage of the managed fund.
If you believe that a certain fund manager has special insight into the market, you may be right. Some managers are born with this gift, but many fake it. It is more likely that the fund and manager(s) in question simply were more lucky with investing temporarily than the others. Clearly it is much more difficult now for fund managers to separate themselves from the pack in terms of superiority than it was twenty years ago.
Index funds do not have active management, but offer the investor a participatory vehicle in this era of vast information processing. Additionally, they are proving to consistently perform above average when compared to similar actively managed funds. The probability is great that an index fund will never be a number one performer in any given year because there will always be a fund that happens to be in the right place at the right time. The trouble is we never know which it will be. We know which it was last year but that doesn’t help all that much. To chase performance like that is a losers game.
Some would argue that index investing is akin to throwing in the towel as far as mutual fund selection is concerned. Some say that we should not strive for mediocrity. We shouldn’t give up trying to find that great fund and manager. We should select well managed superior funds that will outperform the index. I too felt that way in the past. There still may be superior management which will outperform indices consistently, but they are few and far between, worse yet we can’t be certain which ones they may be. An index fund is almost guaranteed to outperform the average mutual fund of its classification.