Five Indexing Pitfalls

Jeremy Glaser: From Morningstar, I am Jeremy Glaser. Building a portfolio out of index funds might seem easy, but is hardly foolproof. I'm here today with Christine Benz. She's Morningstar's director of personal finance, and we'll take a look at five errors that indexers should try to avoid.

Christine, thanks so much for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, let's talk about the first error. I know, a lot of people look over a time period and say, "Hey, look, this index fund's performance has beaten that of actively managed funds by a really huge margin." Is this a fallacy that could get some people into trouble?

Benz: Well, I think, it is, and we do see this from time to time. So, indexing over long periods of time is a nice low-maintenance way to run a portfolio. What you typically see is that index funds, because of their low-cost advantage, tend to beat active funds by small margins, when you look out over 10 or 15 years.

But what you see over short periods of time is that various index funds can look downright unassailable. So we saw this in the mid-to-late '90s with S&P 500 index funds. The mega caps were really doing tremendously well. I think, investors looked at S&P 500 funds and said, "Well, these funds will always beat active funds, and they'll beat them by a big margin." And the same thing happened with the MSCI EAFE funds back in the '80s, when Japan was doing really well and Japan was a big constituent of EAFE funds. People looked at EAFE and said, "Wow, that's a great index to be invested in. I'll always be able to beat all actively managed international funds."

So, you have these little blips in performance where index funds trounce everything else. We've seen it recently with Vanguard's Intermediate-Term Bond Index, when the market had its little shock in late July, early August. We saw these funds rise to their absolute top in the intermediate-term bond fund world. That was I think more of a short-term blip than anything to count on long haul.

I think, you want to think about your index fund as being a competitive performer versus actively managed funds over long periods of time, but don't expect huge margins of outperformance, if you are in it for the long haul.

Glaser: It might be a bit of an understatement to say that exchange-traded funds have garnered some buzz in the indexing community. What should someone who wants to build an index portfolio know about ETFs, if, let's say, they're already invested in traditional open-end mutual funds?

Benz: Well, one thing that I think it could trip people up right now is they're hearing all this buzz about ETFs--hearing about the benefits of tax efficiency, the things you hear about how costs can be lower in some cases than is the case for traditional index funds. And what I would say is rather than upending a whole portfolio of traditional index mutual funds, really do your homework on what you would face in terms of tax costs and transaction costs, to make that trade because it simply may not be worth it if all you're doing is swapping one very low-cost index fund for an ETF that maybe just charges a couple basis points less. It may not be worth it for you to make that switch. So, do the math. Morningstar has a cost analyzer tool that will help you evaluate whether it's worth making a trade based on what you already have invested.

Glaser: Now there are really a tremendous number of indexes out there, but usually when people think of stocks, they focus on the S&P 500 or maybe even the Dow Jones Industrial Average. Can this lead to some problems when trying to compare performance between your index portfolio with say an actively managed portfolio or even among different indexes?

Benz: Well, it can, and this is something that we've highlighted a lot in the past. A lot of people, if they have any actively managed U.S. stock fund, they compare it with the S&P 500. Well, if it's a fund that focuses mainly on small and mid-caps, it's not really a fair fight. Small and mid-caps have been great performers during the past decade or relatively great, whereas the mega caps that dominate the S&P 500 haven't done, as well. So, what we always say is just make sure that you're doing those apples-to-apples comparisons when you're gauging a fund's performance and when you're gauging an index fund's performance.

So, with those broad-brush benchmarks, such as the S&P 500, the MSCI EAFE, or the Barclays Capital Aggregate, those will work if your fund is broadly diversified and concentrates on those same spaces, but they won't be good benchmarks if you have an actively managed fund that does something else. So, you want to be sure to be comparing apples to apples. We have a lot of good tools on Morningstar.com. Certainly comparing your funds' returns versus a category is a good place to start. Or you can also look at what we call best-fit indexes; those are indexes that are finely calibrated to match a specific fund, that way you are making accurate comparisons, which is really important when you are gauging performance.

Glaser: One of big benefits of index funds can be to remove some of the idiosyncratic risk of maybe owning individual stocks or highly concentrated portfolios, so you don't necessarily pick the next Enron out of the crowd. But are there still risks to be had even if you have a broadly diversified index portfolio?

Benz: Well, there are. You're right; owning an index fund will give you exposure to a specific market segment. And it will also protect you from having a manager, who happens to be leaning the wrong way in a certain market environment. So the funds don't have cash, and you won't be caught on the outside looking in at a big rally.

But I think it's a big mistake for anyone investing in indexes to assume that they are risk-free. They can hold just the same risks that active funds hold. So, you need to know what's in your fund. And it's also very important, anytime you're dealing with any sort of more concentrated portfolio, whether it's a sector fund or a regional fund, to know what kind of biases are baked into that portfolio due to its construction. So, if you own Vanguard Telecom Services, for example, you better like AT&T and Verizon because it's 46% of that portfolio. So, some of the sector- and region-specific funds are very concentrated in individual holdings. They are by no means low-risk, and it's really important to have your arms around just how diversified or how not diversified that particular portfolio is.

Glaser: Some investors see index investing as being truly passive, but others are a little bit more active in their take, where they are moving in and out of sectors on a fairly regular basis and changing the asset allocation fairly often. Is this adding any potential risk to the portfolio?

Benz: I think so, and this is the big one actually, and that's why I saved it until last. As investors have more of these tools, have more ways to slice and dice the universe of stocks or bonds, I think that what you'll see is unfortunately investors hopping around more incurring trading costs, and in some cases just not getting these timing decisions right. This is because they are hopping in and out of sectors using as we've talked about some of the leveraged products, some of the inverse products. And my fear is that they can really shoot themselves in the foot by being too active even though they are using passive products.

Our colleague, Jeff Ptak, has been monitoring the universe of tactical asset-allocation funds. These are funds run by professional managers. What he's found is that these managers--and these are pros--have not made a great record of being able to tactically asset allocate. And I think for individual investors or even financial advisors trying to use such active strategies, that really ought to call into question the success rate that they might have with these active strategies. So just a cautionary note, my fear is that even as investors have embraced index funds, they could be using them in the wrong way.

Glaser: Well, Christine, thanks so much for your thoughts today.

Benz: Thank you, Jeremy.

Glaser: From Morningstar, I'm Jeremy Glaser.