Dispelling Myths About Indexing

June 25, 2014 (PLANSPONSOR.com) – The effectiveness of indexing as an investment strategy has clearly taken hold in the industry, as evidenced by the difference in cash flows between active and passive strategies over the past six years, contends Vanguard.

“Despite the theory and publicized long-term success of indexed investment strategies, criticisms and misconceptions remain,” Vanguard says in the white paper “Debunking Some Myths and Misconceptions About Indexing,” which examines those misconceptions. The concept of indexing is all about investments targeting a specific market benchmark in terms of returns, says Chris Philips, senior investment analyst with Vanguard’s Investment Strategy Group and co-author of the paper.

Indexing only works in efficient markets. According to the paper, one of the most persistent myths in the investment industry is that it makes sense to use an index strategy in efficient markets, for instance with large-capitalization stocks, but to use an active strategy in inefficient segments. The fallacy of the “efficient-market” myth is that the underlying objective of indexing is to own the market (whatever that market may be) and to get the return of that market (minus costs), the paper says. The indexing concept makes no judgment as to market efficiency, size, or style, nor does it need efficient markets to be effective: Every market will always have an average return, whether the market is deemed efficient or otherwise. Well-managed index funds strive to minimize all the costs of investing in a particular market. If a plan sponsor wants to gauge how well-managed and index fund is, the best way is by looking at the tracking error of the fund over time, says Philips, who is based in Valley Forge, Pennsylvania. The tracking error is the difference between the return an investor receives and that of the benchmark they were trying to emulate. “This can show how effective the fund is in meeting its investment objectives,” he tells PLANSPONSOR.

Indexing is for average investors. This is an intuitive myth that plays to the fears of the human psyche, according to the paper. Why limit yourself to “average,” the myth says, when you have the chance to be exceptional? The reality, however, is that index funds, in their attempts to deliver the average returns of all investors in a particular market, have delivered far-from-average performance. An important reason for this is cost. Indexing has proven to be a low-cost way to implement an investment strategy, lending a significant tailwind in producing above-average returns over the long term relative to higher-cost active strategies. “The average performance of active managers usually underperforms the benchmark, so good results using this approach are actually more of a long shot. Simply investing in a benchmark or index fund, rather than having an investment manager handle things for you, means a lower cost and a greater diversification of investments,” explains Philips.

You get what you pay for--Higher cost + higher rating = higher returns. The paper notes that highly rated funds have actually underperformed against their lower-rated peers. “What is comes down to is that investing is really hard and the higher price of a fund hasn’t translated into positive returns over time,” Philips says.

Market-cap weighting overweights the overvalued. The reality is that cap-weighted indexes fully reflect, at any point, the aggregate view of every investor in a particular market, voted on by the investors’ actual dollars, according to the paper. As to why market capitalization has worked so well as a way of structuring an index, Philips says, “The price of a security equals the collective wisdom of its investors. You also have to remember that if it were so easy to choose investments that produce good returns, then all investors would be getting such good results.”

Index funds underperform in bear markets. According to the paper, we often hear that a benefit of active management is that the manager can move into cash or defensive positions to curb portfolio losses during market downturns or bear markets. In reality, the probability that these managers will move fund assets at just the right time is very low, the paper says. Most events that result in major changes in market direction are unanticipated. In terms of when index funds perform best, during market upswings or downturns, Philips says that it is not one or the other. The market represents investors’ collective positions and active managers have a challenge in both types of market conditions.

In terms of how these myths affect indexing strategies with defined contribution (DC) and defined benefit (DB) retirement plans, Philips says, “There is always the allure of outperformance, but there are challenges in the DC world. Plan sponsors and investment committees, as well as participants, need to worry about factors like future returns and market volatility. The perceived need, by these stakeholders, for active management of investments may actually be greater now. In a lower return world, a lot of people think they need to squeeze more out of what they have, and that could mean thinking about active management.” When it comes to DB plans, plan sponsors or trustees may be wondering if they are doing their duty by simply accepting the benchmarks, says Philips, wondering if better returns could be achieved.

The white paper can be found here.