The ongoing success story of low-cost index-fund investing
03 June 2019 | Portfolio construction
Commentary by Jan-Carl Plagge, senior investment strategist, Vanguard Europe.
Index investing has been familiar to institutional investors for decades, and the retail market in the US had access to the first indexed mutual fund in 1976. Since then, it has consistently shown to be a successful way for both professional and mainstream investors to harness the power of the markets at low cost.
In Europe, the adoption of indexing has picked up significantly over the past ten years. A big driver of this growth has been changes in regulation. Since the Global Financial Crisis (GFC), the cost-effectiveness and transparency of investment vehicles have come into sharp focus for regulators. These two areas are among the key benefits of index funds.
Cost and transparency
Investors themselves have also become much more cost-conscious. The proliferation of online cost and performance comparison tools has helped investors to gain a much better understanding of the impact that high costs can have on their investment returns.
What’s more, the development of exchange-traded funds (ETFs) as an investment vehicle that mainly focuses on indexed strategies has allowed investors to gain simple, low-cost access to a range of markets.
Traditionally, debate around the relative merits of indexing was often focused on comparing the latest performance data of index and active funds. But more recently, it has become increasingly clear that the appeal of index funds is underpinned by logical arguments that do not change over the course of a market cycle.
The zero-sum game
The theoretical case for indexing revolves around the concept of investing as a zero-sum game. The index return is defined as the capitalisation-weighted average return of all the investments that make up that market. So, for each position that outperforms the index, there must be another position that underperforms by the same amount.
But this even distribution between the outperformers and underperformers only applies before costs are taken into account. After costs, over half of the assets in a given market will underperform the weighted average, which is represented by the index. And the higher the cost of investing, the higher this hurdle to outperformance will be, as the chart shows.
Chart 1: Market participant returns after adjusting for costs
This theory is supported by real data, which show that, across a wide range of sectors, time periods and conditions, the majority of funds underperform their benchmark indices over the long term.1
The impact of cost
In most areas of life, the more you pay for something, the better the product you expect to get. But the cost of investing is counter-intuitive, as there’s no reason to assume that you get more if you pay more. Every euro you pay for management fees or trading commissions is simply a euro less earning potential return. And, just like returns, the impact of costs compounds over time, slowing investors’ progress towards their goals.
This applies to all funds – both active and index. In fact, cost is among the biggest enemies of successful investing. A significant body of research suggests that not only is high cost a major impediment to success, but low cost is actually the best predictor of future outperformance.2
The growth of indexing shows no sign of slowing
The concept of the zero-sum game is reflected in real-world fund performance data, and this has helped to drive the growth of index funds and ETFs over the past decade.
These mathematical realities have played out in practice for many years and going forward, there is no reason to believe that they will change. The regulatory backdrop is also supportive for indexing, with the focus on cost and transparency set to intensify as European countries continue to adopt regulations born out of the GFC. Based on a solid theoretical grounding and supported by the tailwinds of regulatory change, indexing is likely to continue to grow in popularity in the years to come.
1 For more information on this and other arguments presented in this article, see the Vanguard white paper entitled The case for low-cost index-fund investing, James J. Rowley Jr., CFA, David J. Walker, CFA and Carol Zhu, April 2019.
2 See for example Financial Research Corporation (2002), Morningstar (Kinnel, 2010)
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