Why You Shouldn't Put All Your Money in Index Funds
Stock index funds are performing superbly as the bull charges ahead. But don’t look for them to protect you when the market stumbles.
Among mutual fund analysts, John Rekenthaler is one of the best. A Morningstar veteran, he writes a regular, must-read column. So I was surprised to read the first sentences of a recent piece: “Do active funds have a future? To cut to the chase: Apparently not much.”
Rekenthaler is as dead serious as, in my view, he is dead wrong. Look at his case: Over the 12-month period that ended June 30, 68% of new fund investments have gone into index mutual funds, index exchange-traded funds and other passive strategies (passive means a human is not picking the stocks and bonds). A mere 32% of fresh cash went into actively managed funds — those run by well-paid managers who decide what to buy and sell.
Don’t get me wrong. Index funds have a lot to recommend them. The best ones — many of which are run by Vanguard — offer a low-cost way to invest in broad market indexes. I myself have offered index portfolios to readers. Over time, broad stock market index funds have regularly beaten about two-thirds of actively managed stock funds. And it’s a lot harder than it looks to identify in advance the one-third of actively managed funds that will beat their index competitors.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
In short, I think index funds have a place in virtually every portfolio. But, in my view, few portfolios should consist entirely of index funds.
Why? Because index funds are designed to give you all the upside of bull markets and every bit of the downside of bear markets. Only good actively managed funds can protect you from some of the pain of a bear market.
Today, 5½ years into a roaring bull market, the clamor for index funds belies common sense. Paying 0.5% or 1% of assets annually for active management seems like wasted money to many.
Contributing to the rush into index funds has been the unusually strong performance of Standard & Poor’s 500-stock index recently. Over the past 12 months, the S&P 500 returned 22.9%, and Vanguard 500 Index (symbol VFINX), one of the largest S&P index funds, gained 22.7%. The fund’s one-year return outpaced 73% of mutual funds that focus on large U.S. companies. Moreover, U.S. stocks have beaten most foreign indexes handily of late, and I fear that some naïve investors conflate S&P 500 index funds with all index investing. (All returns in this article are through August 19 unless otherwise noted.)
But consider FPA Crescent (FPACX). Steve Romick and his team have delivered an annualized 9.1% return over the past 10 years — beating the S&P 500 by an average of 0.8 percentage point per year.
The main secret to Romick’s success lies in dodging much of the damage of the 2007-09 bear market, when the S&P 500 plunged 55.3%. FPA Crescent lost only 27.9%. Yes, the fund’s annual expense ratio of 1.14% is high compared with the fees charged by index funds, but, in this instance, it’s worth it. Today, the fund has just a bit more than half of its assets in stocks and most of the rest in cash.
And FPA Crescent is hardly the only conservative stock fund that promises to soften the pain of the next bear market. Matthews Asian Growth & Income (MACSX), which lost 39.4% in the 2007-09 bear market, and Vanguard Dividend Growth (VDIGX), which lost 42.3%, are two more fine examples.
Among broker-sold funds, Rekenthaler himself points out that every American fund with at least a 15-year record has beaten its relevant index over that time.
Part of the enthusiasm for passive strategies is aimed at esoteric and often expensive ETFs that invest according to “rules-based” formulas. Take Guggenheim Insider Sentiment ETF (NFO). It invests in 100 stocks whose shares have been heavily bought by corporate insiders. Such insiders have been shown in numerous studies to be savvy investors in their companies’ shares. The ETF charges 0.65% annually. But I’d rather pay a bit more to have a smart manager consider not just the level of insider buying but other criteria as well.
As for the broad-based index funds, they make sense a lot of the time for a lot of investors. But the wholesale rejection of actively managed funds makes no sense at all — and will cost investors dearly during the next bear market.
Steven T. Goldberg is an investment adviser in the Washington, D.C. area.
-
Should You Invest in CDs? What to Consider
Before putting your money in a certificate of deposit (CD), you should know why banks issue them, how they are used and how they are priced.
By Brian Skrobonja, Chartered Financial Consultant (ChFC®) Published
-
How Retirees Can Minimize the Net Investment Income Tax
One strategy is to consider your filing status, which can affect the net investment income tax (NIIT) that successful retirees pay on certain investment income.
By Derek A. Miser, Investment Adviser Published
-
How Inflation, Deflation and Other 'Flations' Impact Your Stock Portfolio
There are five different types "flations" that not only impact the economy, but also your investment returns. Here's how to adjust your portfolio for each one.
By Kim Clark Published
-
Stock Market Today: Stocks Close Lower as Tech Shares Slump
Weakness in several Magnificent 7 stocks created headwinds for the main indexes Friday.
By Karee Venema Published
-
Stock Market Today: Stocks Swing Lower as Chipmakers Slump
The main indexes erased an early lead Thursday as several semiconductor stocks sold off.
By Karee Venema Published
-
Stock Market Today: Stocks End Mixed Ahead of Retail Sales, PPI
Stocks took a breather Wednesday as investors looked ahead to tomorrow's inflation data.
By Karee Venema Published
-
Stock Market Today: S&P 500 Nabs New Record Close After February CPI
Strong gains for Oracle and Nvidia helped the main indexes brush off hotter-than-anticipated inflation data.
By Karee Venema Published
-
Stock Market Today: Stocks Struggle Ahead of February CPI Report
The main indexes had trouble getting off the ground Monday as Wall Street waits for tomorrow's inflation update.
By Karee Venema Published
-
Where Can the Magnificent Seven Stocks Go in 2024?
The Magnificent Seven have been driving stock returns. Here, we take a close look at the mega-cap hotshots to see what's next.
By Nellie S. Huang Published
-
Stock Market Today: Stocks Go Into Reverse as Nvidia Slumps
The main indexes were initially higher after the release of the February jobs report, but ended well off their session highs.
By Karee Venema Published