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Timothy Middleton If You Can’t Beat the Market, Why Not Match It?
1990s to the more modest growth of the twenty-first century, global stock markets have taken a pum- meling. The Vanguard 500 Index Fund, the form of the Standard and Poor’s 500 benchmark in which buyers of stock can invest, eked out annual returns of 2.8 percent in the ten-year period that ended on December 31. That was one quarter of the fund’s historic average and only about half of the returns of municipal bonds, which are normally con- sidered a much more conserva- tive investment.
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Novice investors have inter- preted these results to mean that stocks are to be avoided. Profes- sionals, on the other hand, be- lieve it is a chance to buy equi- ties at bargain prices. Donald Yacktman, founder of the Yacktman Funds, says investors should be as eager to find low prices for securities as for things they would buy in a grocery store. “When lettuce goes on sale at the supermarket, shoppers buy it,” he notes. “When stocks go on sale, investors turn them over, looking for brown spots.” And when it comes to buying stocks, there is no strategy that performs better over very long periods than buying index funds. Index funds are funds that blindly follow benchmarks like the S&P
8
S the world economy adapts from the super- charged growth of the
The only upside available to a bond investor is the security of the government guarantee.
500 or the Dow Jones Industrial Average.
Indexing is so effective that
John Bogle, founder of Vanguard and the creator of the first index fund that tracked the S&P 500 index, recently told the Wall Street Journal that over the past
five
years, index funds as a group were the only stock market funds to see investors put more money in than they took out, with the assets of these funds “now total- ing two trillion dollars, one fourth of all equity fund assets.” Here is why indexing is so pow-
erful, why now is a great time to be buying index funds, and how to implement an index fund-based strategy in your own financial planning.
Why Indexing Works
There’s no magic to indexing. Benchmarks like the S&P 500 and the Dow Jones Industrial Av- erage simply add up the collec- tive experience of every investor in the stocks that make up an index. Since the indexes don’t change very much from year to year, funds that follow them have very low trading expenses and generate very small tax liabili- ties. And since there are no judg- ment calls to be made, the funds don’t have to cover the salaries
of research associates and se- curities analysts, let alone pay for travel expenses and office space for employees.
According to Morningstar Inc., Bogle’s fund charged investors 0.17 percent in expenses in 2010, the last year for which it has complete data. The average fund of a nonindex type fund charged 1.12 percent in ex- penses. So someone with $10,000 in Bogle’s fund paid fees of $17, while another person in a nonindex fund paid $112— more than six times as much, in fees. The more money you have invested in index funds and the longer the investment lasts, the more these small savings are magnified.
To match the returns of the index funds, actively managed funds have to earn market-beat- ing returns because they have to pay their own expenses as well as deliver at least average re- turns to their shareholders. While you might think that professional investors would be able to do that, the fact is that in any given year, according to Bogle, 80 per- cent of nonindex funds fail. What’s more, the 20 percent of funds that do overcome this hurdle tend to show varying re- sults year by year.
Why Now Is the Time Traditionally, conservative in- vestors have invested in bonds, particularly in US Treasury bonds, for a secure guarantee and a relatively high yield, which is cal- culated based on the percentage of the principal that is paid out each year. Those who turn to stocks under normal
circum-
stances are willing to give up a measure of that yield in exchange for a higher expected rate of growth. But at the end of 2011, Bogle’s fund—by far the largest equity mutual fund in the world— was yielding 1.94 percent, almost exactly as much as ten-year Trea- sury bonds. The only upside available to a bond investor
is
the security of the government guarantee. Stock investors can expect returns in the high single digits from the capital growth over time. Meanwhile they can enjoy their dividends.
This relatively high yield in divi-
dends is the mirror image of rela- tively low stock prices. At the end of 2011, Bogle’s index fund had a price to earnings ratio of twelve, meaning the market price of
the underlying stocks was
twelve times this year’s forecast for earnings per share. The his- torical average for stocks is around fifteen. In grocery store terms, this is equivalent to let- tuce having been marked down to $1.00 a head from $1.25. (Continued on page 72)
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