Why do index funds keep winning? And can we do better?
Broad-based equity indexes, like the S&P500, keep beating anyone and everyone. This is especially true over long periods of time. Why? Lot’s of ink has gone into explaining it, but the TLDR boils down to two reasons:
- Low fees
The low fees part is easy to explain, and has been a very powerful factor in the past. The combined performance of all equity market participants before fees is the market itself. Add in the fees managers charge, and then they under-perform the average. Thus, by investing in the market itself with minimal fees, we can perform better than 50% of managers after fees. Compound this differential consistently over years and you’ve got powerful out-performance. Not bad for almost zero effort right?
The consistency argument is more nuanced, but arguably a much bigger reason why index funds keep winning. Index funds, especially those that track broad based equities like the S&P500, are a back-test everyone agree on. A systematic strategy that everyone agrees to follow. To make it even better, everyone benchmarks against it! So from a psychological perspective, it’s easy to stick with, because you’re literally following the benchmark.
This combination of low fees and consistency create an almost unbeatable combination over the long run.
What if we could neuter these advantages?
How? By making sure whatever ‘investing’ we do, also has these two advantages. We need to consistently follow a systematic strategy and make sure we run it with low fees.
So we want to beat the S&P500, what advantages can we get over it? The investable universe of the S&P500 is just stocks. We aren’t constrained by that though, and that gives us the benefits of asset-class diversification that the S&P500 doesn’t have. What else? We can combine these asset classes in interesting ways. Additionally, we can lever their exposure up and down through volatility targeting (hopefully cheaply) to dynamically target our required risk exposure.
So how do we come up with our market beating strategy that has low fees?
Any one of these works (along with many others!):
Most thoughtfully constructed Tactical Asset Allocation strategies can also be used. AllocateSmartly is a good place for tracking many of these.
Okay so maybe I’ve convinced you (a bit). Let’s turn devil’s advocate and discuss what the disadvantages of going down this dark path are.
Caveats of going down the dark path of trying to beat index funds or “if only it were that easy!”
No matter how good the strategy, we’ll still have periods of under-performance where we’ll look stupid in front of the market index.
We’ll look different. In good times we’ll feel pretty good, but in bad times we’ll feel horrible. This is because our bad times won’t necessarily coincide with the market’s. They say misery loves company, but we’ll be pretty lonely at this point. This is exactly the time where we’ll be most tempted to abandon our strategy, killing any supposed advantage our strategy had.
Buying and holding an index fund without re-balancing will have lesser tax liabilities than more active strategies that we run ourselves. This tax disadvantage would be another headwind our strategy would have to overcome. This doesn’t apply for tax-advantaged accounts though like IRAs and 401ks though, which is good news.
The vast majority of people are served well by index funds. For those willing to put in a bit more effort, it’s important to recognize the reason index funds win in the long run and realize that if we have the wherewithal to replicate their advantages (stay consistent and implement our strategy with low fees), it’s not ‘impossible’ to beat index funds.