Losing With Index Funds
Last week, I received a call from a family friend, Ethan. His father, Michael, needed help as Ethan was convinced his dad was getting ripped off.
Out of college, Ethan took an accounting job with an oil company in Houston. In his free time, he dabbled with investments. As such, his father sought help managing his portfolio.
Ethan admitted he didn’t have enough time to manage investment portfolios but wanted to help. So, Ethan modeled out a portfolio of index funds.
I asked him why he thought Michael was getting ripped off.
Ethan said, “I recommended index funds because they are cheap. I modeled out the funds I recommended, but his performance is way below what they should be. He must be getting taken advantage of. How else could his performance be so bad?”
We reviewed Michael’s holdings and transactions. Quickly, the picture took shape. Michael was not directly getting ripped off.
Ethan told his father to buy two index funds. One followed the stock market and the other followed the fixed income market. Ethan intended an 80% allocation to stocks and 20% to fixed income.
Although Michael bought the funds, he veered off course. His allocation shifted to 20% stocks thinking they were risky and 80% to fixed income thinking they were “safe.”
Over decades, stocks generally produce returns of about 10% per year, while fixed income assets produce half that much. Even though they used the same funds, the allocation mattered significantly.
Additionally, Michael used different share classes with a variety of internal fees. These fees drain performance and are only visible if you are highly skilled at reading a prospectus. Michael never received a bill for these fees; they just lowered performance.
In studying Michael’s transactions, another conclusion became apparent. He jumped in and out of the market. Michael said the pandemic caused him to sell and then he got back in, but after the market rebounded. The presidential election unnerved him. Again, he traded in and out. The outcome of the tariffs caused him to lose sleep. He traded waiting for an “all clear” signal.
The data was accurate. Although Michael used nothing but index funds, his performance was significantly below what the indices themselves produced.
This offers several valuable lessons.
An index steers you in a direction. However, the asset allocation is just as important, if not more important than merely choosing a fund because it is cheap or follows an asset class.
What kind of index fund are you going to use? People fail to understand there are literally thousands of index funds. They track virtually every asset. They can follow 5,000 companies, or a single company. They can follow real estate, fixed income or cryptocurrency. Just because you own an index fund, does not mean it is a good asset or easily understood.
If self-managing your portfolio, you must be skilled at valuing assets. An index fund is nothing but a bunch of assets. Whether buying one company or a fund of 500 companies, you need skill knowing what you are buying and paying for those assets.
Annually, the S&P 500 index drops about 14% intra-year. And about once every 20 years this index drops 60% over a two-year period. If invested in this index, your performance will also drop 60%.
If retired and living off your portfolio, the combination of withdrawals accompanied by a 60% downturn can leave you with no money sooner than planned. This is a tangible warning there is more to managing portfolios than merely buying an index.
An index fund can deliver competent long-term returns. However, jumping in and out will cause you to miss out. This is probably the biggest reason index investors fail to match the performance of an underlying index.
Cheap does not mean good. Hiring a brain surgeon because they are the “low bidder” is absolutely insane. Doing the same with your financial assets is similarly unwise. Access to cheap index funds does not mean you know how to effectively manage them. Don’t confuse a cheap tool with not needing professional assistance. Find someone who is a fiduciary and a fee-only advisor to guide you on this journey. Less than 5% of financial advisors are both fee-only and fiduciary.
Lastly, ask your advisor what you receive for the fee paid. Are you simply paying a broker to sell a product? Or is there additional value-add that enhances the relationship such as risk management, estate planning, tax planning or anything else with a large price tag?
Dave Sather is a CERTIFIED FINANCIAL PLANNER and the CEO of the Sather Financial Group, a fee-only and fiduciary investment management and strategic planning firm.
