Retirement investors likely have read about active investment managers and hedge fund chiefs who warn of the growing “danger” of index fund investing.
Indexing does well in bull markets, they charge, but stumbles in bear markets. You’ll make more trading against indexers in downturns, they claim. Further, they argue, index funds foster complacency among investors.
To which John Bogle, founder of Vanguard Group and the great evangelist of index fund investing, would say, “Pshaw!”
“You shouldn’t buy an index fund because you think it’s a hot performer. Buy it because you’re going to hold it forever,” Bogle recently told Money magazine.
Consider for a moment what an index fund actually does. It tracks the market at a low cost. If you expect an index fund to do its job, that is, to track the market, that means the fund will go up when the market goes up and it will go down when the market goes down.
Or, as Bogle explains, “Look, all I did with the index fund was make sure you got your fair share of the market’s return. Sometimes that fair share is going to be bad, so you’re going to lose money.”
But let’s take these statements at face value. If you are in fact going to hold a fund forever, you won’t lose money — ever. To lose money in an investment you have to sell it for below the cost at which you first invested.
That can happen with any investment, whether it’s a single stock, a concentration of holdings in a single sector or an index fund tracking thousands of firms.
Yet passive investors rarely sell except to rebalance, and that’s selling high, not low. Selling because of a decline is just not part of the plan.
Moreover, if your portfolio includes stocks, bonds, foreign investments, real estate and other asset classes, your level of volatility already is limited. For instance, when stocks fall but bonds move upward, overall portfolio volatility is lessened.
If your other non-stock holdings moving sharply contrary to stocks — rising as stocks decline — portfolio volatility also is lessened. If things get wacky you rebalance, selling off gains in some investments to buy others on the cheap. Volatility in this case is not a bug, it’s a feature.
What about complacency? That’s a problem in theory, but one active investors should embrace. If half of all investors are truly disengaged, that means the activists have fewer people to fight over changes at the management level. We don’t need thousands of Carl Icahns. A few will do.
True danger
These arguments nevertheless overstate the mass of investors and their interests. People investing through pension plans and 401(k)s do not show up to stage public fights with the CEO over dividend policy or corporate strategy.
Nor do the vast majority of retirement investors who use IRAs. The major difference between investors in actively managed mutual funds and index fund investors is the fees they pay — and that’s a serious difference! Up to half of your total return can be eaten by fees alone.
Do active fund managers go to bat for the retail investor on management issues? Absolutely not. Their motivations are entirely different. Active managers are rewarded for gathering assets and for defending their exorbitantly high fees. That is all they do.
To call indexing “dangerous” is a misstatement. It’s active management and high costs that are truly dangerous to the serious retirement investor.
