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The Index Revolution is Thriving

Daniel Solin

In 2006, I wrote "The Smartest Investment Book You'll Ever Read". It laid out the research data supporting evidence-based investing. I told investors which index funds to purchase in order to have a globally diversified portfolio at a very low cost.

In his otherwise favorable review of the book, Paul Brown of the New York Times noted what he called "endless chest thumping" and gave these extracts as examples: "The securities industry adds cost. It subtracts value." And "Virtually all brokerage-based financial consultants and most independent financial advisers manage money using dumb money management techniques." Events since the publication date have fully validated these observations.

A lot has transpired since 2006, including the greatest stock market crash since the Great Depression and one of the fastest recoveries. Those who followed the advice of many brokers and advisers, and fled to safety when the market crashed, missed out on the recovery.

The book went on to become a New York Times bestseller with strong sales every year. Brown's stated wish that "we see more of these kinds of books" became a reality. Financial books are now shorter and provide advice that is much easier to understand and implement. An excellent example is "The Little Book of Common Sense Investing", by John Bogle, founder of The Vanguard Group.

More gratifying has been the reaction of investors who have adopted indexing in droves. Jason Kephart, in an article in Investment News, declared that "John Bogle's victory parade is overdue." Kephart noted that stock funds and ETFs with low expenses had net inflows of $442 billion over the past decade, while those with higher expense ratios had outflows of $368 billion over the same period. Bond funds and ETFs with the lowest costs had inflows of $614 billion. More expensive funds had far lower inflows of $144 billion since 2002. Most of the inflows were to passively managed index funds, which typically have much lower fees than actively managed funds.

It seems investors are finally getting the message that low costs are better predictors of future returns than other factors, like past performance or Morningstar star ratings. In a study done by Russel Kinnel, Morningstar's director of mutual fund research, the findings could not be more clear. Kinnel concluded: "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile."

Even the Motley Fool, while still adhering to discredited notions of stock picking, is advising investors who purchase mutual funds to buy index funds. It's ironic that the Motley Fool has come around to the benefits of indexing since it is the fund manager of the actively managed Motley Fool Great America Fund (TMFGX), which has a net expense ratio of 1.37 percent. Fortunately, investors haven't flocked to the fund, as it only has $95 million in assets since inception on October 31, 2010, according to Yahoo Finance.

I hope one day to be able to write a blog post entitled, "The Demise of Active Management." Until then, I take great satisfaction from the data indicating that investors are moving in the direction of evidence-based investing.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.

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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