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5 Reasons to Add Index Funds to Your Portfolio

Daniel Solin
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Almost 18 years ago, Rex Sinquefield, co-founder of Dimensional Fund Advisors, had this to say about the debate between the proponents of active and passive management: "So who still believes markets don't work? Apparently it is only the North Koreans, the Cubans and the active managers."

At that time, few in the securities industry were particularly concerned about index-based investing. Sinquefield's remarks were mostly ignored. How times have changed. The "debate" has all but disappeared, as the evidence in favor of index investing (which I like to call "evidence-based investing") has mounted.

You need to look no further than the SPIVA funds scorecard for overwhelming evidence supporting the demise of active management. In an article in the "Journal of Indexes", Srikant Dash, formerly the managing director of S&P Indices, noted these "lessons learned" from a decade of tracking the performance of index and actively managed funds:

Outperformance over longer time periods. Over every five-year cycle measured, a majority of actively managed funds underperform their indexes.

Outperformance in bear markets. In the two bear markets over the past decade, a majority of actively managed funds underperformed their benchmarks.

No evidence of performance persistence. Dash notes the chance of finding an outperforming fund prospectively by using past outperformance as a predictor is "similar or less than random expectations."

Fixed income funds fare even worse than stock funds. According to Dash, "Almost all municipal bond funds have trouble beating the S&P National AMT-Free Municipal Bond Index."

Indexing works in small caps. There is no merit to the often-repeated mantra of active managers that they can outperform in the small-cap markets because those markets are less efficient. Indexing works as well for small caps as for large caps.

Investors have taken note of this data and have poured money into index funds, dealing a blow to active managers. According to a Vanguard report (relying on data from Morningstar), at the end of 2012, assets in U.S.-domiciled index mutual funds and exchange-traded funds accounted for 34 percent of stock and 18 percent of fixed-income funds.

A Vanguard study, "The Case for Index Fund Investing for UK Investors," found that active fund managers in a range of funds available to investors in the U.K. have "underperformed their benchmarks across most of the fund categories and time periods considered." Adam Laird, a passive investment manager at Hargreaves Lansdown, commented on the report by noting: "This study is further evidence of an unfortunate truth - many active managers disappoint."

The threat to the traditional securities industry is now too big to ignore. Active managers can't compete based on data, and appear to be resorting to name-calling. The "debate" sunk to new lows recently with a comment in an article in The Financial Times, written by David Smith, a U.K.-based active fund manager with Hargreaves Lansdown Fund Managers. Smith observed that passive management is a "parasitic industry" benefitting from the activity of active managers. Smith observed that index funds "are only an intelligent strategy if you believe active managers keep the market broadly efficient." Smith not only rejects the efficient-market hypothesis but is "amazed" that others disagree.

Vanguard founder Jack Bogle responded to Smith's contention by noting: "Whether markets are efficient or inefficient is beside the point. The cost matters hypothesis is all that is needed to explain why indexing works: gross return in the market as a whole, minus the costs of obtaining that return, equals the net return investors actually receive."

For investors, the shift in tactics by active managers, from ignoring indexing "upstarts" to name-calling, is telling. Presumably, if they had data supporting the basis for their investing strategy and livelihood, they would publish it. Investors would be well advised to focus on the evidence and dismiss the heated rhetoric.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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