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Opting for Index Funds? Don't Set Yourself Up for Disappointment

There are many compelling reasons to choose index funds; performance-chasing isn't one of them.

If you pay even passing attention to the asset-management industry, you know the story: Investors have been opting for index funds in a big way. Flows to passive products, both exchange-traded funds and index funds, totaled $413 billion in 2015. That brought the total assets in all passive products to more than $4.5 trillion (yes, trillion, with a "t") at the end of last year.

There are many reasons for this trend. Investors of all stripes--individuals, advisors, and institutions like 401(k) plans--have increasingly gravitated to passive products because of their low costs, predictability, and transparency. Thanks to their low-cost advantage relative to the typical actively managed fund, index funds have generally delivered returns that are solidly above average relative to their category peers. And with many market experts forecasting equity returns in the mid-single digits, the fact that broad-market equity ETFs help reduce the drag of taxes on an investor's return has further burnished their appeal.

A separate but related trend is that more and more advisors are transitioning to business models where they aim to add value with personal financial planning and customized asset allocation, not security selection.

Those are all healthy fundamental underpinnings for the uptake of passive products. Yet I can't help but notice that some of the biggest beneficiaries of the movement toward index products--U.S. equity index funds, in particular--also happen to have scorching recent performance relative to their category peers. That makes me wonder whether at least some investors who are piling into U.S. equity index funds have unrealistic expectations on the return front. Although there's no reason to expect that cap-weighted index fund performance will fall off a cliff--they rarely if ever do, at least in relative terms--there will inevitably be periods when their performance looks a little "meh" relative to their peers. Being prepared to hold on to index funds through such periods is essential to enjoying their long-term advantages.

Flows Follow Returns

For a look at the possible connection between performance and flows into U.S. equity index funds, let's start with the performance of the past year's top asset-gathering U.S. equity indexers,

Those two aren't exceptional. Indeed, the relative return rankings of the top 10 asset-gathering U.S. equity index funds are robust across the board. Their average three-, five-, and 10-year percentile rankings are 22, 19, and 18, respectively. I'd suggest that those strong numbers have helped hasten some investors' uptake of U.S. equity index products. Many investors and advisors had probably been mulling a transition to index funds anyway; the strong performance pattern helped them get comfy with that decision.

Of course, investors have been buying international and bond index funds, too, and their performance has been underwhelming. Owing in large part to its sizable emerging-markets weighting,

But the inflow data for these asset classes is a bit more nuanced than is the case for U.S. equity funds, where investors are clearly dumping active funds and going index. First, investors have been buying both active and passive international equity funds, not swapping one for the other.

Meanwhile, bond funds depict a similar flow pattern as U.S. equity funds--out with active funds, in with passive--but there's another factor at play: the PIMCO effect. Although active bond funds did experience $71 billion in outflows in 2015, roughly $54 billion of that came out of

Armageddon Not Nigh

Whenever index funds outperform to the extent that capitalization-weighted U.S. equity funds have recently, investors invariably grasp for explanations, and active management partisans often begin devising reasons for index funds' impending demise. For example, some market observers pointed out that the S&P 500 Index's relative success in 2015 rested, perhaps perilously, on the success of the so-called "FANG" stocks--

As it turns out, however, it's not atypical for a handful of stocks to deliver much of the index's return in a given year. Nor does strong performance in a handful of top names portend disaster for index-fund holders.

But there's one performance pattern that holders of capitalization-weighted index funds can take to the bank: Such funds will look best relative to their peer groups in periods when the largest companies outperform, and may look less impressive when they don't. S&P 500 Index funds looked unassailable through the second half of the 1990s, but began to look more pallid relative to their peers starting in 2000. Not only did technology stocks sell off sharply, but then-undervalued small-cap stocks (especially small-value stocks) took and maintained the lead through 2006. By the end of 2007, trailing return rankings for S&P 500 Index funds were middling. A quick flip through our

for Vanguard 500 Index for that time frame shows Morningstar analysts urging fundholders to stay the course despite the fund's lackluster performance. Mega-caps regained their performance edge relative to the broad market in 2011 and have generally maintained it over the past five years, but market favor is bound to shift again eventually.

The bottom line is that even though there's much to like about index funds, their low-cost advantage is their main selling point, and that benefit accrues gradually over time, not in the space of a year or two. Just like active funds, cap-weighted index funds will encounter market environments that test investors' patience. Investors who go in with their eyes wide open to that probability are more likely to enjoy index funds' long-run advantages than those seeking an unbroken string of topnotch results.

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