Q: The Wall Street Journal reports that in the past 10 years, stock index funds have almost doubled to 35 percent of stock fund assets. Assuming this trend continues, what does it portend in terms of whether the stocks that compose these indexes, especially the S&P 500, are fairly valued? More dollars chasing the same investments generally means those investments will increase in market value and trade at higher P/E multiples and other valuation measures. If the relatively smaller handful of stocks in the indexes becomes overvalued, does this suggest actively managed funds that invest in non-index stocks may have a greater potential to outperform the "market"?
A: The trend is healthy for those saving for retirement and other long-term goals. Although the stocks in the S&P 500 may enjoy a slight "index" premium, I'm skeptical that indexing fundamentally distorts market values and market dynamics. Active money managers remain a commanding presence in the market. And I don't think active managers will do any better in the future.
For individual investors, the evidence is overwhelming that most actively managed investment funds fall short in performance compared with broad-based low-cost indexed investments. For one thing, it's really hard to systematically beat the market, the most competitive business in the world. Astronomical sums changing hands everyday around the globe as millions and millions of smart investors (and many more not so smart ones) seek an edge.
Another reason for the subpar performance of active managers is the high fees they charge. For instance, expense ratios on actively managed equity mutual funds averaged 0.89 percent vs. 0.11 percent for index funds, according to the Investment Company Institute. Here are some illustrative numbers. In the 10 years ended in 2013, some 85 percent of actively managed funds in the large-cap stock universe underperformed their benchmark indexes, according to mutual fund behemoth Vanguard. A similar story holds for smaller U.S. companies, developed market equities and emerging market stocks.
Investors can easily create a well-diversified portfolio with razor-thin fees through broad-based equity and bond mutual funds. "By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals," writes Warren Buffett, the stock-picking maestro. "Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb." Not bad.