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Index fund investors' no-fuss approach may enrich returns
PEOPLE who put their money into index funds seem to make fewer decisions than other investors. And that leads to better performance.
That's the implication of a Morningstar study that helps to explain why fund investing often works better in theory than in practice. Just how much better is expressed by a measure called the "return gap".
That's the difference between the reported return of a fund or a group of them and the return - almost always lower - that investors achieve with real dollars in the real world.
There's nothing nefarious going on; the managers aren't skimming off the top. It's just that investors have a habit of moving money into and out of funds at inopportune times, so that each dollar earns a lower rate of return than if it had been invested all the time.
In an extensive study of the phenomenon, Morningstar assessed return gaps in each of six mutual fund categories for the 10 years through March: domestic diversified equity, domestic sector equity, international equity, taxable bond, balanced and alternative.
Researchers found larger return gaps for actively managed portfolios than for index funds in all but one category: international equity. All told, the average annualised return gap was 2.48 percentage points for actively managed funds and 1.84 points for index funds.
Either way, that's a lot of money to be eaten away from returns year in and year out.
A US$10,000 investment in the average index fund at the start of the study period would have grown to US$20,076 a decade later, without taking the return gap into account, according to Morningstar. Factoring in the gap, the typical index investor would have been left with just US$16,883.
If that US$10,000 had been invested in actively managed funds, it would have grown to US$18,231 without considering the return gap. With the gap, the figure would have been US$14,395, or barely half the gain. Morningstar calculated performance in each case by adding together the results of funds from the six investment niches in the study and weighting them based on the assets in each niche.
Investment advisers credit the smaller return gap in index funds not to the funds themselves, but to their shareholders. They contend that investors who are drawn to index funds usually have psychological traits that make them less susceptible to behaviours that increase return gaps.
Switching to index funds by itself is unlikely, therefore, to magically cut into the return gap you otherwise might suffer. But thinking and acting like an indexer could help reduce the gap and improve performance, they say, whatever kinds of funds you own. "Index fund investors are better behaved than active fund investors," said Christopher Cordaro, chief investment officer of RegentAtlantic, a Morristown, New Jersey, financial-planning firm. Two helpful characteristics that he highlighted are humility and patience.
"Investors who favour index funds are likely to be more humble about their ability to time the market," Mr Cordaro said. Trying to hit market tops and bottoms accounts for much of the return gap, in his view, because investors "invariably get the timing wrong". As the only group for which index fund return gaps were larger, international equity may be the exception that proves the rule that the gaps generally result from poor market timing. Investors are notorious for making forays into foreign assets as a run of outperformance is nearly over. Index funds are an easy vehicle for making such tactical plays, while actively managed funds may be the preferred method for achieving overseas diversification for the long haul.
Beyond recognising how hard it is to time market turns, indexers seem to display humility by keeping their goals modest. The smaller return gap, in part, "can be attributed to the expectations investors have on Day 1," said Ben Johnson, director of passive studies for Morningstar.
Indexers know "they will participate in the performance of the market come hell or high water," he said. "That allows them to better manage their own behaviour."
Stock and bond market performance was close to heavenly for almost the entire period of the return gap study. Some question, though, how well index funds will do in a protracted bear market and whether shareholders will stick with them as faithfully as they did when prices nearly always went up.
"The results would be logical and widely expected, but are they reflective of a full market cycle? Probably not," said James Stack, chief executive of Stack Financial Management.
For active managers, "sector allocation and stock selection are used to reduce the inherent risk in a portfolio," he said. "That tends to work against active management in a prolonged bull market, but it works to their advantage in a bear market. Passive funds often look stellar after the end of a very-long-running bull market, but they often will lose more than actively managed funds in a bear market." Mr Stack, who publishes investment advisory newsletters under the InvesTech Research brand, said a combination of worse returns and a tendency of shareholders to hold on longer could raise return gaps for index funds during extended market weakness.
Morningstar's Mr Johnson is sceptical about that, mainly because he doubts the ability of active managers to be all that active in a helpful way during a decline.
"People tend to overlook the performance of active funds in a bear market," he said. "Few are able to get out of the way. In any bear market, investors are going to get skittish in active or index funds." Perhaps, you're already a patient and humble investor (if you do say so yourself) and can avoid the sorts of mistakes that intensify return gaps. So much the better, but even if you're not and are unlikely to change, you may have no choice but to behave more productively if you invest through your employer's retirement plan.
The one category for which the return gap was positive in the Morningstar study, albeit by a thin 0.18 percentage points a year, was balanced index funds, which allocate assets between stocks and bonds. Mr Johnson noted that these funds were likely to be owned through employer plans, many of which have safeguards to protect investors.
"The gap has been positive because, within those funds, we have seen money coming in at regular intervals," he said. Penalties for early withdrawals are another impediment to plan participants making timing calls.
Regular contributions to retirement plans also compel investors to engage in dollar-cost averaging, said Peggy Ruhlin, chief executive of Budros, Ruhlin & Roe, a Columbus, Ohio, financial-planning firm. A practice universally regarded as a safe way to invest long-term, dollar-cost averaging involves salting away the same dollar amount each period, ensuring that more assets are bought when prices are lower.
"A 401(k) plan is the best way to dollar-cost-average," she said. But, she added: "You should follow the same path with money that's not in a 401(k)." Ms Ruhlin, like most advisers, also tells investors to diversify among different asset classes: stocks and bonds, foreign and domestic. When deciding on an appropriate mix, they should consider not just market-related factors, their age and personal financial circumstances, she said, but emotional and psychological factors, too.
"If you're an investor who panics about everything, you should not have an allocation that's 90 per cent stocks," Ms Ruhlin said. "Take into account your own preferences and have an appropriate balance." Diversification helps cut the return gap by smoothing out performance, Mr Cordaro said. That lower volatility limits the chance that purchases or sales will be made at an especially bad time by reducing any sense of urgency to buy or sell, and it reduces the consequences, even if an investor can't resist.
He also recommends regular portfolio rebalancing: lightening up on funds that have risen substantially and buying more of what has declined.
"It's a disciplined way of buying low and selling high," Mr Cordaro said. "The return gap exists because most investors do the opposite." Perhaps the best approach to your investments is to approach them less.
"Find yourself a hobby that isn't checking your portfolio," Mr Johnson said. "The more often you look at what's going on in the market and how it's affecting your investments day to day, the more tempted you'll be to tinker. Tinkering is rarely a positive thing for achieving long-term investment success." NYTIMES