The Case for Index Funds

with a few exceptions most investors should be using lowcost index funds as their primary investment vehicle anyone who disagrees with that statement is probably misinformed conflicted or just plain wrong this is nothing you haven't heard me say before but I want to make the case for lowcost index funds in a single video that can be shared with people who are still investing in high fee actively managed funds as many Canadians are I'm Ben Felix Chief investment officer at pwl Capital and I'm going to make the case for lowcost index funds as the most sensible Investments for most people the case for index funds breaks down into six simple but important points each with supporting Theory and evidence cost efficiency diversification investment returns tax efficiency Simplicity and theoretical consistency before I get there I want to start with some background on index funds I also want to mention that I have some words of caution that I hope you'll stick around to here at the end of the video an index is a grouping of stocks designed to represent a market or Market segment for example the S&P TSX Composite Index is designed to be representative of the Canadian stock market S&P comes up with a list of company names and weights based on the relative sizes of the companies this is called a market capitalization weighted or cap weighted index the S&P 500 is similarly a market capitalization weighted index in this case representing 500 leading us companies a cap weighted index will always have more weight in larger companies like RBC and Shopify and Canada or apple and Microsoft in the US and less weight in smaller companies that you're less likely to have heard of market cap waiting is simple based on market prices and easy to implement which likely explains its widespread use in both benchmarking evaluating the results of another investment strategy and index investing creating funds that track an index an index fund is a mutual fund or ETF that tries to replicate the performance of an index usually by investing in the stocks in the index when I say Index Fund throughout this video I'm referring to cap weighted total market index funds index funds that aim to capture the returns of a total stock market as I'll explain later not all index funds are created equal to contrast an actively managed fund aims to outperform the market index by doing things like selecting a subset of stocks within the market and timing exposure to the market in an effort to outperform over the last 60 or so years index funds have gone from being a fringe idea and academic circles an idea that the asset management industry liked to criticize and even laugh at to becoming a mainstream investment vehicle this did not happen by accident a huge body of academic research starting around 1968 and continuing to today has shown that actively managed funds do not add sufficient value to cover their relatively High fees on average and that the vast majority of active funds underperform in the long run this brings me to the first point in making the case for lowcost index funds index funds have low fees the weighted average fee for index funds in Canada is 0. 19% well for actively managed funds that do not have the cost of advice built in is around 0. 85% those higher fees on average will translate to lower investment returns and no other identifiable benefits unless you really like supporting your fund manager research from Morning Star has found that fees are one of the best predictors of future fund performance vanguard's late founder John Bogle famously said that in investing you get what you don't pay for his point was that unlike other areas of life where paying more comes with the expectation of better results paying higher investment fees typically results in lower returns not higher a point corroborated by research from Vanguard formalizing this logic Nobel laurate Bill Sharp explained what he called the arithmetic of active management in 1991 if active and passive another name for index investing management styles are defined in sensible ways it must be the case that one before costs the return on the average actively managed dollar will equal the return on the average passively managed dollar and two after cost the return on the average actively managed dollar will be less than the return on the average passively managed dollar this suggests in simple terms that in aggregate investors in actively managed funds must underperform investors in total market index funds because active funds have higher fees and costs multiple academic Studies have found this to be approximately true before fees there is evidence that active funds add a bit of value on average but net of fees all credible studies agree that the average active fund is not adding value in addition to fees investors in a fund pay transaction costs in Canada a portion of these costs are reported as the trading expense ratio or teer index funds tend to have very low trading expense ratios often rounding to 0% while actively managed funds which typically trade more tend to have higher transaction costs it's not uncommon for the trading expense ratio of an actively managed fund to be higher than an index fund's fees and trading costs combined as important as fees and costs are a lot of people are not aware that low costs are one of the benefits of index funds only 31% of respondents to a 2022 survey of Canadian investors knew that index funds have lower fees and expenses than actively managed funds as important as they are fees are not the only reason that actively managed funds will tend to underperform their relative lack of diversification also poses a challenge this brings me to the next Point index funds are broadly Diversified by replicating the returns of a market index index funds hold a huge portion of the stocks in the market on the other hand in their efforts to beat the market actively managed funds will tend to hold fewer stocks portfolio concentration can be a good thing if a fund manager knows how to pick winning stocks but picking winning stocks consistently is really hard stock returns are positively skewed this means that most stocks don't perform very well in the long run while a relative few perform exceptionally well the result is that while the long-term Return of the overall Market is positive the majority of individual stocks underperform Based on data from 1926 through 2016 only 42.

6% of US Stocks had lifetime Buy and Hold returns that exceeded one-month treasury bills just over 50% of US Stocks had negative lifetime returns about 12% of US Stocks lost 100% of their value and only 30. 8% of stocks generated lifetime Buy and Hold returns that beat the market suffice to say that most stocks do not beat the market over their lifetimes the data for Global stocks are even more discouraging if a fund manager identifies those relatively few winners ahead of time they will generate High returns but they are much more likely to end up with losers index funds on the other hand always hold the winning stocks this idea was detailed in the 2017 paper why indexing Works which separate from fees helps to explain why active managers tend to underperform a benchmark Index this brings us to the next Point index funds beat the vast majority of active funds in a 2023 study looking at long-term returns for us Equity mutual funds from 1991 through 2020 the authors find that most funds underperform an index fund even before fees will a few funds win big this is important multiple studies including this one find that the average active mutual fund slightly outperforms before their fees but this study shows that most funds 54. 8% of them in the sample underperform an index fund even before their fees are considered the explanation is that the skewness in stock returns makes it more likely for active mutual funds to pick losing stocks than to pick winning ones after fees only 30.