Indexing, for most investors, is a difficult leap of faith.
All of us like to think that someone out there can pick stocks or bonds better than everyone else and that if we happen to invest with that person we’ll get rich faster. This wishful thinking is aided and abetted by unrelenting media coverage of star fund managers; by the publication of countless lists of “bests” and “worsts;” and by repeated stories of how a well-timed investment of $10,000 allowed a fellow from Indiana to buy Sumatra.
We also have the same wishful thinking about investments we make directly, hoping to find the next Dell, Cisco, or EMC so that one skillfully selected stock will rocket us to wealth, a path with much more style than pulling a winning lottery ticket.
In fact, very few investors have track records that survive close examination. Most lose from day one. Those who stand out are routinely buried in money or so wildly enriched that they retire. Still others are later revealed to be the proverbial “flash in the pan.”
Index investing does better.
The reason is offered succinctly by neurologist/investor William J. Bernstein in his book “Intelligent Asset Allocation” ”(McGraw Hill, 206 pages, hb, $29.95).
Indexing costs much less.
Traditionally managed money, whether in mutual funds or individual accounts, suffers from expenses that sap the long-term return. Basically, the professional money manager finds himself swimming against a rip tide of expenses that make it virtually impossible to beat an index of comparable securities.
Bernstein says that there are four major expenses in managing a portfolio. First there is the familiar and highly visible expense ratio of the fund— the management fee and administrative expenses. Then there is the less visible cost of brokerage commissions. Finally, there are costs that are harder to measure and seldom discussed— the bid-ask spread on transactions and the “impact” costs of buying or selling a relatively large block of stock.
All of these expenses are lower for an index fund.
Here are Bernstein’s estimates for three categories of funds:
- Large cap funds. The average large cap domestic equity fund has an expense ratio of 1.30 percent. It also pays commissions equal to 0.30 percent of its net asset value; a bid-ask spread cost that consumes another 0.30 percent, and an impact cost that takes still another 0.30 percent. That brings the total cost to 2.20 percent a year, nearly 10 times higher than the comparable cost of an index fund, 0.23 percent. Cost advantage for the index fund: 1.97 percent a year, every year.
- Small cap and foreign funds. These funds start with larger expense ratios averaging 1.60 percent. Commission expenses are also larger, 0.50 percent. But the real burden is the additional 1 percent consumed by both the bid-ask spread and impact costs. This brings the total cost to an intimidating 4.10 percent a year. That’s nearly 7 times more expensive than the 0.60 percent cost of a comparable index fund. Cost advantage for the index fund: 3.50 percent a year.
- Emerging market funds. These funds are even worse, with expense ratios averaging 2.0 percent a year, commission costs of 1 percent a year, and bid-ask spreads of 3.0 percent. Add an impact cost of 3.0 percent and the real expense burden on an emerging market fund is a whopping 9.0 percent a year. That’s about 6 times the 1.47 percent costs for an emerging markets index fund. Cost advantage for the index fund: 7.53 percent a year.
Using Bernstein’s figures, you can also see that wrap accounts, which include commissions in their annual fee, aren’t a bargain. With wrap accounts commonly offered at 2.5 percent a year but averaging 1.89 percent a year in fees (according to Cerulli Associates in Boston), they are inherently more expensive than the 1.60 percent a year cost of expenses and commissions for the average large cap mutual fund. (The impact of small cap and foreign stocks would most likely be small and offset by cash and fixed income holdings.)
The bottom line: if you are a serious investor— someone who intends to be investing for 10, 15, or 30 years— there is only one mantra for investment success.
Eschew fortune telling. Index and reduce expenses.
Everything else is sport and low amusement.
To visit Bernstein’s website: www.efficientfrontier.com
Photo: Anna Nekrashevich
(c) Scott Burns, 2022