The ‘linked benefits’ of index investing | USAEMALL.com

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a former chair of Yale’s Investment Committee, an ex-board member of Vanguard and the author of 21 books including the forthcoming Rethinking Investing

The idea of linked costs was made clear to me by my father when I was 11 and he asked: “Why does the cinema charge you kids only 20 cents for admission?”

“Because we’re kids?” was my reply. My father said that was part of it but there was also a specific reason that I should understand. After several guesses, he decided to let me in on the secret: the owner of the cinema wanted as many kids as possible to come inside where they might buy popcorn at 25 cents that cost only 5 cents to make.

Later, while doing graduate work in economics, I learnt that the commercial world has many similar linked costs, including what we are learning to call “junk fees”. Happily, there are examples in this complex world of what might be called “linked benefits”. One rather generous source of these comes with tracker or index fund investing.

By now, everyone must be alert to the reality that index or tracker funds charge much lower fees. If you assume equities are likely to return 8 per cent over the long term, then finding a good way to get lower fees certainly makes good sense. If actively managed funds charge 0.85 percentage points of total assets as fees and indexers charge 0.05 points, shifting from an active manager to an indexer would save 0.80 percentage points, increasing net returns by 10 per cent per annum.

Focusing again on linked benefits, we know 90 per cent of US funds underperform the S&P 1500 Composite index over 10 years, according to data from Spiva. This is because expert professionals with access to superb research (including increasing use of artificial intelligence), extraordinary computer power and Bloomberg Terminals are making the markets harder and harder to beat or match, particularly after fees and costs of operations.

So, another of the linked benefits of indexing is not suffering persistent and, apparently, increasing underperformance — and anxiety for the investor about their fund being particularly disappointing. Yet another linked benefit is much lower tax liability because portfolio turnover is so low with indexing.

But the big linked benefit stems from behavioural economics. Actions taken by investors in the sincere desire to improve portfolio performance actually harm returns. Since most of us do not keep careful records, it is hard to realise the extent of this. But by striving to do better, the average US equity investor — and we are all much closer to average than we recognise — hurts their performance by more than two percentage points in an average year, according to study by research firm Dalbar of returns over the 30 years to the end of 2023.

In an 8 per cent return market, this works out as a 25 per cent share of returns. Most people would agree that this is substantial. (And if you are looking at real returns after inflation, the impact is even more)

Indexing rides to our rescue for a reason seldom associated with equity investing: boredom. Indexing is not exciting, it is boring. When markets go up or down suddenly, the impressive thing about indexers is how little they do and how little they notice or care about changes in stock prices. With 500 different stocks, there must be a few with a lot going on, but there are a great many stocks that have nothing or nearly nothing going on. So, index investors accept and learn to appreciate the value and benefits of indexing, diversification and benign neglect.

Long-term indexers, if they are wise, recognise that the centrality of their investing career is that in their thirties and forties, they are saving to spend in their seventies and eighties during retirement. If thoughtful, they will recognise that such long years of investing give them the opportunity to harness the power of compounding returns.

However, those who don’t index will incur more costs and will experience lower returns. The issues highlighted by behavioural economics would claim 2 percentage points a year. Active manager fees and costs of operations and taxes would take another 1 point. While these items may seem small when stated as a percentage of assets, when stated as a percentage of returns, particularly after adjusting for inflation, they seem quite large. Compounding reveals the true value of long-term investing and minimising costs. And the best way to minimise costs of all kinds is to index and capture the numerous linked benefits of indexing.