Recommended by finance experts and used extensively by experienced institutional investors,
index funds and exchange-traded funds (ETFs) provide unmanaged, diversified exposure to a wide variety of asset classes – from large and small cap stocks to growth and value, international equity, and even fixed income. At IndexEdge, we use these cost-efficient index structures to build diversified, balanced portfolios that are ideal for long-term investing.
By eliminating the extra, ongoing money management fees charged by other investment structures, our clients can generate immediate cost savings and dramatically improve their long-term portfolio growth.
Institutions Index, So Should You
Many people assume that sophisticated institutional investors (such as endowments and pension funds) hire traditional money managers to actively invest the bulk of their large portfolios. In reality, it is estimated that more than half of large institutional investment holdings are now indexed – to gain efficient, diversified market exposure for the “core” portion of their portfolios. In many cases, hedge funds, private equity, and other active management structures are then carefully screened and selected in an attempt to provide excess returns, or alpha, to the “satellite” portion.
Notably, all four of the largest public pension funds in the United States now index more than 70% of their domestic equity holdings. In fact, CalPERS, California’s state pension fund and the largest in the country with approximately $180 billion in assets, indexes over 80% of its domestic stock portfolio. Interestingly, most retail investors follow an inverse approach – with approximately 90% of all retail holdings invested in actively managed products and only 10% invested in cost-efficient index structures.
Active Manager Underperformance
Experienced institutional investors have moved rapidly to indexing strategies for two primary reasons – cost-efficiency and performance. Surprisingly, the vast majority of professional money managers and stock-pickers – approximately 90% − underperform comparable, low-cost index funds when time periods of ten years or greater are considered and after accounting for expenses and taxes. (Unfortunately, the small percentage of money managers who – from time to time – exhibit superior performance, typically follow this with random periods of subpar performance, a well-established pattern called “reversion to the mean.”)
Why is this? Because modern financial markets have become increasingly efficient through improved technology and increased regulatory oversight, new, relevant information about companies is rapidly digested and reflected in their market prices. As a result, it is incredibly difficult – if not impossible – for traditional, “long-only” investment professionals to consistently identify undervalued securities that will produce above-average gains.
Benjamin Graham, the legendary pioneer of modern security analysis and value investing strategies, noted the effects of increasing market efficiency on his own techniques for selecting stocks. In the twilight of his career, he made this fascinating admission: “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say 40 years ago, when Graham and Dodd was first published. I doubt whether such extensive efforts will generate sufficiently superior selections to justify their costs.”
Ongoing Management Fees Are Extremely Harmful
In addition to their long-term underperformance versus comparable index benchmarks, many investors would be surprised to learn that the total costs of owning an actively managed mutual fund can be approximately 2.5% − 4.0% per year – once the management fees, administrative costs, trading costs, 12b-1 fees, and sales charges are included (or approximately 1.5% − 2.5% per year for the industry’s newest product line, called “separately managed accounts”).
By contrast, low-cost index funds and ETFs, which provide diversified exposure to the same asset classes and industry sectors, have internal fees which average approximately 0.10% – 0.25% per year.
Does this seemingly small difference in annual costs really matter? Consider this startling calculation. If you have an initial portfolio valued at $500,000, which earns a hypothetical 10% net return for 40 years, an additional 2% in extra, annual fees taken from your returns will result in $11.7 million in potential growth lost to extra, ongoing costs. (See The Cost Calculator™ for an interactive demonstration.)