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Asking the Right Question of Index Funds

Common sense is indeed common, but it's not always sensible.

John Rekenthaler, 06/13/2017

The Loser's Game?
Index funds did not take the mutual fund industry by storm. Five years after its debut, Vanguard 500 Index had $90 million in assets, which made it a modest sales success by the standards of its time, but scarcely the vanguard of a revolution. Ninety million dollars was also the total of the industry's indexed assets, as neither Vanguard nor a rival had launched a second index fund.

The initial marketing was stymied by the effective, but misguided, claim made by indexing's early critics--that index funds always lose. Every active fund has the chance to beat its costless benchmark. However, index funds are guaranteed to trail. Because they mimic the costless benchmark but then add expenses (and trading costs), they inevitably fail. They lag their benchmarks, every year.

This criticism is largely true, although not entirely. Expenses do indeed drag down the returns of index funds when compared with the theoretical indexes that they track. However, as costs for the big index funds are slight and there is some fluctuation because the funds' portfolios do not exactly match the indexes', on occasion such funds will sneak past their benchmarks. For example, another Vanguard index fund, the Admiral share class of Vanguard Total Stock Market (TSM), has done so three times in the past 15 years:

The chart would seem to support the early critics. TSM has indeed been inferior to the costless Wilshire 5000 benchmark that it simulates. (OK, technically TSM tracked the Wilshire 5000 until 2005, then for business reasons switched to a very similar index provided by the Center for Research in Security Prices.) In 15 calendar years, TSM beat Wilshire 5000 three times, tied once, and lost on 11 occasions. It didn't trail by much, to be sure, but it nonetheless did so, and will just as reliably do so in the future. In addition, it doesn't compensate for that shortfall by having lower risk than does the Wilshire 5000.

The Real World
However, the comparison is flawed because investors can't buy the Wilshire 5000. Nobody can, not even the largest and most sophisticated of institutions. Those seeking broad U.S. stock market exposure can select TSM, or they can select a rival fund. The real question, therefore, is not whether TSM can beat a theoretical construct, but instead whether it beats the living, breathing funds (so to speak) that investors can purchase.

And we know how that turned out. In TSM's case, the results have outdone even the index enthusiasts' expectations:

is vice president of research for Morningstar.

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