The amount of attention “Index Funds” have been getting lately is insane. It seems that I either read or hear about index funds on a daily basis now; it has really picked up over the last year. And rightly so, the capital flows into indexed products (whether index mutual funds or index ETF’s) has been astronomical. In 2016, $285 billion was pulled from actively managed U.S. mutual funds. During the same time, U.S. index-tracking funds had inflows of $429 billion!! Vanguard is kicking serious ass in this trend, they had the top FIVE funds in terms of capital inflows in 2016.
Now, this is all fine and good with ol’ Andrew Jackedson. In fact, much of the money flowing into index funds over the past year has been my own. For decades, mutual fund companies (in general) have been overcharging their clients for under-performance. Some might even dare to say that mutual funds (in general) have taken advantage of their investors’ ignorance, and even intentionally made their fee structures too complex for the average investor to understand. This certainly seems to be the case with many fund families, especially when you start looking at all the share classes and different ways they have charged investors over the years. A shares, B shares, C shares, F1, R6, Z shares, loads, CDSC’s, 12-b1 fees….this shit is confusing!
So Jack Bogle and Vanguard (many, many others have followed) have come along and turned the industry on its head. Indexing is simple, cheap, and has a proven track record. Actively managed funds will now have to compete by becoming simpler and less expensive; the consumer (the investor) wins. Yay!!
HOWEVER, there seems to be a strange cult-like following of Jack Bogle, Vanguard, and index funds in general. I have noticed that there are people out there who are forming very strong opinions about investing, yet know very little about it. Fueled by their excitement about just how awesome index funds are, these individuals have no problem yelling their investment advice from the rooftops! The following example is a comment I was unfortunate enough to read on a Wall Street Journal article about 401(k) plans:
You should NOT follow this advice, as it is terrible advice. Even though index funds do have low turnover, you still pay capital gains tax on all dividends while you hold the fund, and capital gains taxes on your gains when you sell the fund. Plus, if you follow his advice, you have already paid income tax and are investing what is left over. The tax deduction (which defers your income taxes) in a 401(k) is a huge benefit. You can go online and find many different calculators that will show you this. The benefit will look something like this:
Even IF you were in a 401(k) plan that had above average fees and ONLY expensive mutual funds as investment options, it would almost certainly still be more advantageous than investing in ‘low cost index funds’ in a brokerage account. (BTW, the average 401(k) participant has an all-in cost of 0.64% of assets.)
Additionally, most employers offer a match and/or profit sharing. If a participant stays with the company long enough to get vested, this is a 100% return! This is huge! Can you name any other situation where you get a 100% guaranteed return on your money? I can’t…
Most importantly, this is not an ‘either/or’ situation. Many 401(k) plans offer index funds as investment options. Many 401(k) plans have very low (or no) costs to the participant, and many (most?) offer mutual funds with ‘institutional’ share classes with very low expense ratios. Furthermore, periodic contributions are a great thing. They allow 401(k) participants to “dollar cost average” into the market on a ‘set it and forget it’ basis; not try to time the market like the fool that made this comment.
The real problem here is that these index cult followers believe that index funds are some type of magic bullet. The answer to every investment question or problem is: “Index funds!” But the reality is that ‘index funds’ are just another investment product, and ‘indexing’ is just another investment strategy. There are hundreds of index funds tracking all sorts of indexes, all with various expense ratios. Investing is complex. There are many factors that need to be considered (costs, taxes, time-frame, risk tolerance, etc.), and it takes a broader level of understanding than just “index funds are the best” to be a successful investor.