If you have ever seen a return percentage posted for a fund you are invested in and have thought, “I don’t believe I have received that appreciation with my investment dollars”, you are not alone. The performance gap, how an investor’s personal return stacks up against that of the fund they are invested in, is typically cited and used as the leading argument by those who propose that passive index investing is the answer to all of our investing troubles. Index funds are an important tool that can be used to maximize performance and mitigate risk, but it should be viewed as one of many tools in the investor’s toolkit and not as the one tool that can magically work on any type of bolt or screw.
Rather than looking at the performance gap in actively managed funds, which can be the result of many things such as improper benchmarking, investment methodology, and fees, we will look at the performance gap of an index fund. With index funds being very low in cost and the manager of the index fund simply replicating what is in the index, we can isolate investor behavior as the culprit of any performance gap. For the cleanest picture of this let’s examine a fund that is widely used by both individual as well as institutional investors, Vanguard’s S&P 500 index fund VFINX.
By looking at information provided by Morningstar, the expense ratio of VFINX is 0.16%, a very low cost for a fund. Further, there are no upfront loads to exacerbate performance drag. Morningstar provides both fund return as well as investor return data for VFINX. The trailing 15-year return of VFINX is 5.36% whereas the investor return for this fund over the same time period was 3.21%, a gap of 2.15% annualized. The same disparity is revealed when you examine the 10 year numbers as the typical investor fell short by 2.44% annualized. As fees and management style cannot be the issue with an index fund, this data demonstrates that investor behavior is a major contributor to underperformance. Unfortunately, these are the subpar returns realized by a lot of investors who invest in index funds but do not have a trusted guide at their side to help curb detrimental behavior tendencies. Having isolated the fee issue, this result can be blamed only on investor behavior. Fees are no doubt important, but they are not the only factor to consider. Index funds, while cheap, will not solve the problem of investor behavior, which has a far greater impact on investor returns than fees..
Now, let’s take a look at where we are at today. The S&P 500 has been on a 5-year tear fueled by growth stocks trading at historically very high multiples. As a result of this torrid pace, many prudent active managers have shunned these stocks and have lagged the index in recent years. Because of the lagging performance, some investment firms and media outlets have started to typecast active management as an archaic novelty, encouraging investors instead to pour all their investment dollars in to index funds. High priced stocks, performance chasing, financial media frenzies, “innovative” new financial products… sounds like a recipe for an investor behavioral trap. It is exactly at moments like this, historically, that investors’ behavior tends to act opposite their best interest. A huge flight to index funds will tend, over time, to result in a massive misallocation of capital that cannot continue indefinitely.
A lot of investors consider the financial landscape an area that they are not knowledgeable about and consider to be overwhelming at times. There are a lot of people who are willing and want to provide direction but who are not trustworthy or don’t know what they are talking about. Without a map or an advisor who has knowledge of the ‘lay of the land’, it is more than likely that you will get lost and you will not reach your financial goals. An independent, fiduciary financial advisor is there to help guide you on the right path by relying on their knowledge and by using every prudent tool that is available, not just one tool everyone keeps saying you must have.