Let’s Talk Investing! (Feb. 03, 2011)

by fishhook

Today, let’s focus on the “indexed” stock fund. Indexed funds are designed to mimic a certain index, the s&p 500 for example, and will provide a less-than-index-average rate of return. Mutual fund sales people will argue that the return will not be that much less, however, if you choose the “low cost” funds offered by Fidelity and others. Indexed funds are touted by many mutual fund companies, their famous founders, and their sales staff, as one of the best forms of stock investing over time. Are they really?

Advantages of Indexed Funds:

1) Indexed funds are easy for you to manage. You are essentially buying all the stocks in the index, and you don’t have to manage anything except for when and how much you buy and sell over time. The mutual fund company does not as actively manage the indexed fund either. This so-called “passive” management leads to lower expenses, and greater returns, than most actively managed mutual funds.

2) Indexed funds while offering a rate of return that is less than the index average, nevertheless will provide that lower rate of return over time which can grow with compounding for the future. (This of course assumes that the market will go up). Importantly, again, the low-cost indexed fund typically will offer a greater rate of return than the vast majority of the actively managed, typically higher expense funds. That said, we will discuss shortly how indexed funds are indeed managed by the mutual fund companies to your detriment in ways that you perhaps had not considered.

Disadvantages of Indexed Funds:

1) Investing in indexed funds is more expensive than you think. There are hidden costs that investors must bear. Even though indexed funds are not actively managed, the indexes which they mimic are actively managed. Consider the s&p 500 for example. The ranking of the 500 largest companies changes nearly every second of every day. For the largest companies at the top, this is of no consequence. Many companies come in and out of the s&p 500 at the bottom, however, and this dropping and adding of companies results in periodic public announcements by the S&P in advance. What do you think happens to the share prices of those companies to be dropped and added after the announcements are made, but before the S&P actually adds or drops those companies from the index? Bingo! Arbitrage opportunists sell those stocks in advance of the s&p dumping them from the index, and they buy those stocks in advance of the s&p adding them to the index. Because the indexed funds try to mimic the s&p as exactly as possible, in order to minimize tracking error, they wait to buy and sell until the changeover date. This means that the fund, and you, are buying those stocks being added at a higher price than is necessary, and you are selling the dumped stocks at a lower price than is necessary had the fund instead acted prior to the actual date announced for changing those bottom-tier stocks. A 2006 study of this phenomenon estimated the annual cost of this practice to index fund investors to be between $1 and $1.2 Billion. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=922296

2) Now, one might think that this is a small price to pay for adding new, hopefully more profitable companies to the index while at the same time dropping the stocks that no longer qualify. A 2008 study however analyzed the impact of “rebalancing” on returns of the Russell 2000 index. As it turned out, a “buy-and-hold” index portfolio that kept the “losers” and did not add any new “winners”
each year actually outperformed the annually rebalanced index during the 5-year study period by 17.29% over the five years. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1272512 The fact is that investing in index funds is not as low-cost a strategy as you may have thought. Some have even said that investors should stop making Bogle and other Bogleheads rich, and start using their own brains, but yours truly would never be so crude as to say that. That is for you to decide.

Are There Better Alternatives?

1) With an ample amount of armor to protect my vital areas, as well as to gird my loins, and several garlic bulbs hung strategically around my neck, I am constrained to answer this question in the affirmative.

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a) Professor Jeremy Siegel of the Wharton School has analyzed data for approximately the last 50 years which indicates that high yield stocks outperform the index averages, even before the added costs of mutual funds, by amounts surely worth considering for the average investor. For example, his research verifies that the Dow-Jones Industrial Average has outperformed the S&P index, and moreover that the 10 highest yielding stocks in the Dow 30 each year has outperformed the Dow. From 1958 – 2003, the Dow10 provided an average annual return to investors of 14.43%. http://www.jeremysiegel.com/index.cfm/fuseaction/Display….Page/page/strategies_dow10.cfm

b) Confirming Siegel’s research over the more recent time frame, the Dividend Aristocrat’s List includes companies which have increased dividends for over 25 years in a row. It is equally weighted and re-balanced once a year. Over the past 3, 5 and 7 years this index of elite dividend stocks has managed to outperform the S&P 500 by 5%, 3.7% and 4.40% respectively. http://www.dividendgrowthinvestor.com/2009/12/dividend-aristocrats-list-for-2010.html

c) Finally, before we move beyond the benefits of high yielding stocks, Ned Davis Research (no introduction necessary), has also proven that dividend paying stocks outperformed non-dividend paying stocks in the S&P 500 over the time frame from 1972 to 2010. http://www.dividendgrowthinvestor.com/2010/06/6-dividend-stocks-which-beat-index.html

d) Rob Arnott, a 30-year veteran of financial analysis, and the co-author of “The Fundamental Index: A Better Way to Invest” (Wiley 2008), has found that indices that are not based on market capitalization perform about 2% better than indices based on market capitalization. For this reason he argues that is it better to invest in indices based on fundamentals, such as P/E, price/sales etc., than on the typical s&p 500 cap-weighted “indexed fund”. “Fundamental weighting gives investors a boost over cap-rated weighting.”(Harry Markowitz).

e) Last year the family of Vanguard mutual funds became the largest in the industry. They and others preach that index investing beats stock picking and market timing. Clearly to any objective observer, however, it is no longer a fair debate whether high yielding stocks have outperformed the indexes. They have. Fundamental approaches to indexing have also outperformed cap-weighted indexing. Dare I even say it, with an extra garlic necklace around my neck now, but we would be remiss if we did not at least explore the potential that market timing, that horrible taboo, can also help an investor beat the index averages. As only one example, Investor Monkey has developed a method based on “mutual fund flow data” that has helped them significantly outperform the indexes for the last 3.5 years. It makes fundamental sense that stocks will advance when money is flowing into mutual funds, and that stocks will stagnate and/or decline when money is withdrawn from mutual funds. Their results over an admittedly short time frame (although one that included both significant bear and bull moves) have indeed been excellent: “During the past 3.5 years the SPY returned an average of -0.4% per month. This is our benchmark. When there was an inflow of funds during the previous month, the SPY returned an average of 0.15% per month. When there was an outflow of funds during the previous month, SPY returned an average of -0.69%. Overall, our strategy returned an average monthly return of 0.50% per month compared to -0.40% per month for our benchmark. This means that our strategy beats an average John Bogle Vanguard investor by 0.9% per month or by 11.3% annually during the past 3.5 years.” http://www.insidermonkey.com/blog/2010/09/30/how-to-beat-index-funds-by-more-than-10-per-year/

There are other ways to beat the index average without incurring much, if any, additional risk. But, heck……I have been advised that I don’t know anything about investing………….the question really is, what do you think? Your feedback and additions to this discussion are welcomed and appreciated!! I hope this one stirs a little interest and we look forward to some great contributions!!

Thanks for your comments…………….and all the best!!


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