Indexing's Most Overlooked Benefit: Consistent Returns

More than thirty years after Jack Bogle introduced the first index mutual fund to the world, the indexing debate, in many circles, rages on. Most investors acknowledge that index funds typically outperform the "average" actively managed equity fund over time. At the same time, many just can't shake the notion that they're an above-average investor. And given that the average includes so many dogs that no one in their right mind would own, merely eliminating those losers as an option gives an investor a big leg up in selecting the next big winner.

Perhaps. But that logic ignores an often-overlooked benefit of index funds -- the relative predictability of their returns. True, you'll rarely find an index fund at the top of the performance charts, but you'll rarely find one at the bottom either. That consistency leads to some surprising results.

I have a friend who's a bit of a know-it-all. He's a nice enough guy, but extremely confident in his abilities. We were talking about our investments the other week, and indexing came up. He dismissed it, as he always does, as too "simplistic" for his tastes, something suitable for those who didn't know any better, but not for someone who followed the markets as closely as he did. "I like to use a more sophisticated approach to investing," he said. "I think the work I put in will pay off over time."

It's not hard to understand why so many people feel this way, because in almost every other field there is a somewhat direct relationship between the price and sophistication of a product and the value you can expect to receive from it. You expect a $25 meal to taste better than one that costs $5, for instance. You expect a $30,000 car to be more reliable than one that costs $10,000. You expect a $300,000 house to offer nicer and more numerous amenities than one that costs $100,000. And so, naturally, many investors infer that an investment approach that's complex and expensive is superior to one that's simple and low-cost.

Investing: A Zero-Sum Game
The problem is that investing is unique from most other fields of endeavor in that it's a "zero-sum" game. If I do my homework and successfully purchase a reliable car, that has absolutely no impact on your ability to do the same. On the other hand, if there were only 100 cars available to purchase, half of which were perfectly reliable and half of which were lemons, my successful purchase would directly impact your ability to do so -- for every successful purchase, there would be another that was unsuccessful.

Investing is the same way: for every investor that outperforms that market, there's another who underperforms by the same amount -- for every winner, there's a loser. Just as it's impossible for all car buyers in the example above to choose a reliable car, so is it impossible for all investors to outperform the market average. And after the costs of investing are paid, investors as a group actually underperform the market's return by the amount of those costs.

Costs and Consistency Matter
And costs matter -- a lot. Largely because of its cost advantage, Vanguard's Total Stock Market index fund has outperformed 62 percent of all large-cap blend funds over the past ten years. Over the past 15 years, it's outperformed 67 percent. But beneath that solid long-term success lies a critical benefit of indexing -- consistent returns, relative to the market.

Consider one of the funds my friend used as an example of his ability to identify future winners, Thompson Plumb Growth. Since 1996 it has provided an average annual return of 3.4 percent, nearly a dead heat with Vanguard's Total Stock Market Index fund, which returned 3.5 percent for the same period. "It's hit a rough patch," my friend acknowledged, "but it will bounce back."

Perhaps it will, but his experience highlights the benefit of consistent performance. Consider the chart above, which depicts each fund's performance by quartile each year for the entire period. You'll see that the index fund's performance has been remarkably consistent, falling into the third or fourth quartiles just once in the 12 year period. Thompson Plumb Growth's performance, on the other hand, has been quite erratic. The number of times its performance has been in the upper-half of all large-cap blend funds (six) is nearly matched by the number of times it's appeared in the bottom quartile (five).

What Does This Mean to You?
Consider the experience of an investor who invested $1,000 quarterly into each of these funds. At the end of 2008, the investment in the index fund would have been worth $45,000. The investment in Thompson Plumb Growth would have been worth $37,800 -- nearly 20 percent less than the index fund's growth, despite an average annual return for the period that was nearly equivalent. How did this happen? Because, as you can see, the Thompson fund achieved most of its success early in the period -- when our investor had little in the fund -- and found itself in the bottom quartile in four of the last five years -- when most of our investor's money was in the fund.

What we see is that relative consistency matters. As we've all re-learned in the past year, investing in the volatile stock market is quite difficult enough. If you add an additional layer of volatility on top of that, in the form of an actively managed fund that moves, often wildly, above and below the market from year to year, it's possible to find yourself trailing the stock market, even if you were fortunate enough to chose a fund that managed to keep pace with -- or even nominally exceed -- the market's return over the long term. Consistency and relative predictability are worthy goals for all investors -- even the most sophisticated among us.

Investment-guide image via Flickr user thelastminute, CC 2.0