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Are Index Funds The Best Way To Invest?

Are Index Funds The Best Way To Invest?

July 29, 2020
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Investors are increasingly voting with their wallets, and the clear winners are index mutual funds and exchange-traded funds (ETFs).  These funds don't attempt to pick the best (or avoid the worst) stocks and bonds, or the best time to be in/out of the stock and bond markets.  Instead, they buy and hold an entire group of stocks or bonds and only sell them when they disappear (through bankruptcy, default, or foreign company buyout).  There are several obvious advantages of index funds: low costs (so you get to keep more of your returns), tax efficiency, and broad diversification.

Compared to traditional "actively managed" funds, both stock and bond index funds have been superior.  The chart below is from a study done by Dimensional Fund Advisors.  It looked at all US stock and bond mutual funds that were in business in 2000, then tracked their returns over the next two decades.  Surprisingly, the vast majority of active managers did not even survive!  They performed so poorly they went out of business or merged with other funds.  Only 41% of stock mutual funds and 42% of bond mutual funds were still around after 20 years.  Of the survivors, only 22% of stock funds and 10% of bond funds beat their index.  The vast majority -- 78% and 90%, respectively, did worse.

But what about the winners?  Some outperformed, why not just invest in those instead of settling for index returns?  Because we know who the out-performers have been, but we don't know who they will be.  The DFA study also looked at the top performing 25% of stock and bond funds over all five-year periods, and then followed their returns over the subsequent five-years.  Guess what they found?  Previous winners don't repeat by any more than we'd expect by chance.  Only 21% and 29% of stock and bond funds who out-performed managed to stay on top during the following five years.  You'd expect similar results if you picked funds out of a hat.  

So indexing is the clear winner compared to traditional stock picking/market timing (i.e. "active management").  Does that mean the case is closed? Not so fast. Index fund investing falls short when we consider how markets really work.  If all stocks and bonds had the same long-term returns, we could buy low cost indexes and expect the best outcomes.  But we know that's not the case.  In US, international, and emerging markets, we've see that different types of stocks have dramatically different returns.  Over time, small stocks have outperformed large stocks, low-priced value stocks have outperformed growth stocks, and stocks of companies with higher profitability have outperformed those with lower profitability.  

Instead of settling for index funds that ignore these differences (often called "dimensions") in expected return, investors can instead use the "asset class" mutual funds from Dimensional Fund Advisors (DFA) that emphasize these findings.  DFA's (newer) growth funds tend to hold more profitable stocks, their value funds tend to hold much lower-priced value stocks while excluding unprofitable stocks, and their small company funds tend to buy the smallest of the small stocks, with an emphasis on the lowest priced and most profitable companies.  Their "Core Equity" funds invest in the entire stock market but emphasize smaller size stocks, lower-priced stocks, and the stocks of more profitable companies.  Over random one-, three-, and even five-year periods, Dimensional's superior fund design leads to outperformance in most, but not all, periods.  Over time, Dimensional's combination of index-like diversification and low costs, with the added benefit of a focus on higher expected returns, has lead to a better investment experience.

Looking back over the last 20 years, we see a phenomenal and unprecedented result.  Except for the DFA US Large Company fund, which is actually an S&P 500 Index fund (that only underperformed by 0.02% per year despite a 0.08% expense ratio), every single core Dimensional stock mutual fund -- in US, international, emerging markets, and real estate, outperformed their index!

Let's consider this in the context of everything we've learned.  Over the last 20 years, 59% of all stock mutual funds did so badly they disappeared.  Only 22% of all stock funds (2 in 10) outperformed.  But with Dimensional, excluding the actual index fund, all 12 of their funds outperformed.  12 for 12.  In some cases, this outperformance was significant; in eight of 12 comparisons, based on a hypothetical $100,000 investment, the DFA fund came out ahead by more than $50,000!  That's real money.

Are index funds the best way to invest?  They're good, for sure.  You're better off in index funds than actively managed funds.  But index funds are not the best.  In every important asset class you would want to own as a long-term investor, theory and evidence/data confirm that Dimensional's "asset class" mutual funds come out way ahead.

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Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.