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The Odds Favor Index Investors

Index investors have the highest probabilities of meeting their investment objectives. The returns of index funds are better than the average active funds in every investment category, and portfolios of index funds romp portfolios of actively managed mutual funds. The job of creating an all-index fund portfolio is easy because there are funds covering every asset class in every style in nearly every market around the world.

The choices we have available can be attributed in large part to the Vanguard Group of mutual funds. Thirty-five years ago, Vanguard CEO John C. Bogle along with his meager staff launched the first publicly available index mutual fund. It was named the Vanguard First Index Trust, later renamed the Vanguard 500 because it tracks the S&P 500 index.

This novel index fund was a long-shot from the start because Vanguard had no reputation, no actual assets under management, and the distribution model was horribly flawed. Vanguard was prohibited from distributing the fund directly to the public per an agreement with its parent company, the Wellington Group of Mutual Funds. The fund had to be sold through the Wall Street brokerage channel, and brokers didn’t like the idea. To add insult to injury, the commission Vanguard offered the brokers was only 6.0 percent, while the average commission on competing funds was 8.5 percent.

It was widely known in the 1970s, as it is today, that sales commissions drive broker behavior. The University of Pennsylvania Wharton School studied the correlation between commissions and fund sales in early 1970s. Unsurprisingly, they found that higher commissions motivated more sales among brokers regardless of what they were selling. The study also noted that high commission funds produced lower returns than low commission funds – a fact that has never concerned Wall Street.

Reaction to the Vanguard 500 among brokers was as predicted. The offering period attracted only $11 million in assets, which was far below the $150 million target. A new fund with so little in assets should have never made it out the door. However, a bold decision was made by the Wellington board and in August 1976, the world’s first publically available index fund became a reality.

The brokerage distribution model was dumped within a year after Bogle negotiated an agreement to separate Vanguard from Wellington. The shackles were off Vanguard as John Bogle and his small crew set a new course into unchartered waters.

Fast-forward ahead 35 years: Indexing has become a dominant force in the mutual fund marketplace. Today, more than 15 percent of all mutual funds are index funds and they represent 20 percent of the $8 trillion mutual fund market. Vanguard remains a major force in the space by managing approximately $900 billion in indexed assets including mutual funds, ETFs and private accounts.

Indexing grows because indexing works. The low cost, tax-efficient practicality of index investing has generated returns that have beaten the average actively managed mutual fund in every asset class, every investment style, and in every country around the globe.

Vanguard has recently released a white paper on performance entitled The Case for Indexing. It documents the poor results of active management versus indexes over the years — a result that worsens over extended periods. The following chart illustrates the decreasing success rate of active management.

The data includes actively managed funds that have gone out of business or merged with other funds. Active funds covering the international equity markets have also performed poorly, and bond market funds were the worst performers compared to appropriate benchmarks.

The performance of individual actively managed funds isn’t the whole story because most investors don’t own one fund. People own a diversified portfolio of stock and bond funds and perhaps alternative asset classes such as real estate. This invites the question, how would a portfolio of all actively managed funds have compared to a portfolio of all index funds?

A portfolio that holds only index funds in different asset classes has a very high probability of beating a portfolio that holds only actively managed funds in those asset classes. The table below highlights the probability of an all-actively managed fund portfolio outperforming an all-index fund portfolio.

There is a 30 percent chance that a single actively managed mutual fund will outperform an index fund over a 10 year period of time, but that probability drops to 9 percent when three managed funds in a portfolio are judged against three comparable index funds. The results get worse as more active funds are added and as more time passes. A portfolio with 10 active funds held for 20 years has only a 1 percent chance of beating a comparable all-index fund portfolio.

Index fund investing has proven to be the best strategy for most people. A low-cost index portfolio has the greatest probability for meeting long-term financial goals. It’s not the most glamorous way to get the job done, it’s just the most reliable way — and that’s the bottom line.