Indexing: The Triumph of Experience over Hope

Warren Buffet in 1996:

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

In chapter 5 of John Bogles's Common Sense on Mutual Funds, he makes his case for index funds.

What is an index fund? It is simply a mutual fund that holds a basket of stocks that meet a specific definition. They are not chosen by a single person, or by an investment committee, or by some formula.

The Dow Jones, S&P 500, and NASDAQ are index's. The Dow is 30 large US stocks, the S&P 500 is the largest 500 stocks in the US, and the NASDAQ is the market of technology stocks. An index fund is a mutual fund that replicates a particular index.

If you own the S&P 500 index fund, you own the 500 largest stocks in the US. Nobody picked those stocks in that fund, they are there because they meet the definition of 1 of the 500 largest stocks in US.

There are now hundreds of index funds available to investors. Including everything from a total US market fund to small cap value funds to international funds to specific industry funds, ie health care.

What studies have shown is that over time index funds perform better than funds that are managed by investment professionals.

Bogle shows that over the last 40 years the S&P 500 index earned 9% while the average actively managed equity fund earned 7.6%

To clarify:

The S&P is a good index to represent the total US market. By definition it is the average of all the investors investing in the market. And therefore, by definition, roughly half the investors will be better and half will be worse. Then, when you factor in expenses, it is nearly impossible to consistently outperform an index net of fees. A look at the above numbers demonstrates this. The average fund fees for mutual funds are approximately 1.3% to 1.5%. So if the average mutual fund earns the market average (since all equity mutual funds are essentially the market) of 9% then subtract the fees., the net return is the 7.6% . A mutual fund would have to earn better than 10% to beat the index net of fees.

It is primarily due to the fee issue that index funds outperform over time. This exists over all types of index funds. It mathematically has to: actively managed funds have higher expenses and if the index in every category is the average, the net active return has to be lower than the average (net of fees). This last argument is not mine it is William Sharpe's - 1990 Nobel prize winner in Economics.