Heres why I no longer own an S&P 500 index fund
In the latter half of the '90s I had an S&P 500 index fund, which I exited as the market went south. This post lists the rationale behind my decision to -- at least for now -- avoid S&P 500 index funds.
Note: The S&P 500 index represents approximately 70% of the value of the U.S. equity market. And in recent years, funds based on this index have become very popular with mutual fund investors.
[09/08/2005 - Read more posts on this topic: A new category has been added for the index fund debate.]
First, here are some advantages of owning S&P 500 index funds
- Low operating expenses
- Low turnover (leading to reduced expenses and potentially lower taxes)
- More efficient use of funds (reduced need for cash reserves)
- Wide industry diversification
- In recent years, S&P 500 index funds have outperformed 70-90% of all domestic equity mutual funds
So when it comes to S&P 500 index funds, whats not to like?
Before sharing my rationale, you should know that it is my opinion that the '90s bull market was like a 50-year storm, and is NOT something we are likely to see again anytime soon. Rather, I operate under the assumption that -- at least for the next few years -- U.S. equities will at worst continue to trade sideways, and at best, deliver moderate upside growth.
Here are some specifics on why for now I am avoiding S&P 500 index funds:
- I don't feel I need to settle for average: By definition, the performance of an index fund is the average for the basket of companies that make up the index. I believe that its worth the effort to seek out funds that have a consistent long-term record of beating the average.
- I don't believe that now is the time to "handcuff" a good manager: By definition, index funds have no discretion in regards to how money may be allocated in response to changing market conditions. I believe that -- at least in a soft market -- a limited amount of discretion in the hands of the right manager can lead to superior results.
- I want the fund manager free to look beyond U.S. equities: The S&P 500 are all U.S. companies. In todays market, I would prefer to see managers have the option to incorporate fixed income and international holdings into their asset mix.
This data backs up my decision
The following chart compares one of my favorite holdings -- Dodge & Cox Balanced -- with the S&P 500 index over 6 different periods of time.
Pay particular attention to the 1, 3, 5 and 10 year performance -- which demonstrates that in a soft and sometimes volatile market -- an actively managed (balanced) approach can beat the S&P 500 index.
For an investment made 5 years ago, Dodge & Cox Balanced has left investors with 97% more money than did the S&P 500 index
Out of curiosity, I ran the numbers through a compound interest calculator and here's what I found: Using the chart above, and assuming cumulative returns for the most recent 5 years, investors who bought D&C Balanced would have nearly TWICE AS MUCH MONEY as their counterparts who matched the S&P 500 index for the same period.
Note: Dodge & Cox Stock fund has outperformed their Balanced fund in almost all time periods. As a conservative investor, I am still more comfortable with a balanced approach. Currently both D&C Stock and D&C Balanced funds are closed to new investors. But you still have options...
Want to find more funds like Dodge & Cox Balanced?
Recently I searched Morningstar's Fund Screener looking for quality balanced funds. Based on my criteria, Morningstar listed 5 funds that beat D&C Balanced. If you do go this route, you would be well advised to conduct research on 5 - 10 funds that meet your criteria.
Related posts
10 Reasons Why I Like My Dodge & Cox Fund
Dodge & Cox Balanced Fund: '05 Mid-year Review
Buying mutual funds: This money-saving tip often overlooked by mainstream press
Three reasons why I no longer buy or sell individual stocks
And don't miss fatboys well articulated: Why I don't buy mutual funds
Please remember that I am not a financial planner. My decision is based on my personal experience and how I feel in my gut. So please feel free to leave a comment telling us how you see it.
[09/08/2005 - Read more posts on this topic: A new category has been added for the index fund debate.]
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I would caution potential investors about comparing a balanced fund, which contains stocks, bonds and cash, with a pure stock fund like an S&P500 index fund. A S&P500 index fund would be just one part of your portfolio. When making decisions about which funds to invest in, it is important to consider the return and volatility of your *complete* portfolio, not just the component funds. If you were just invested in a single fund, then the balanced fund might be more appropriate than the S&P500 fund since it is likely to be less risky (stability due to presence of bonds/cash).
Thanks for your comment. I believe that this type of discussion is valuable for myself and readers.
Here is a little more insight into my thinking: It is likely that the S&P 500 index will beat the balanced account in bull market. But I am willing to potentially leave something on the table (in a bull market) if it means gaining better results in a soft market.
I am also a fan of managed accounts. So admittedly I have a bias for the balanced approach.
Also of interest, Dodge & Cox Stock fund which is 100% Stock -- beat the S&P 500 index by an even wider margin for the 1, 3, 5, 10 and 20 year periods.
Michael is correct: although I strongly believe that an S&P 500 index fund has a place in almost every investor's portfolio, it should NEVER be the only holding, and the percentage of the portfolio allocated to this index should drop as the investor ages and/or their risk tolerance level drops.
1stMill,
Passive investors such as myself also do a variation of what you are talking about ("leaving some returns on the table" for better returns in bear markets). Except that instead of choosing actively managed funds, passive investors construct a portfolio of different asset classes with low correlations (us stocks, foreign stocks, bonds, etc) and rebalance their portfolio perhaps annually. Just as you are attempting to do, this smooths out the returns over time, but you never get the full return of any asset that does well in a particular year.
My initial comment was not to say that the Dodge & Cox Balanced was a bad fund (in fact it looks good for an active fund with a low 0.54% ER), but just that I thought you were doing an apples to oranges comparison. A more valid comparison IMO would be to compare it to something like Vanguard's Balanced Fund, although some might argue that would be a stretch since the Dodge&Cox is more Value-oriented.
When you buy and hold an index fund like the S&P500, you're not 'settling' for average. In fact, the after-tax net returns tend to be superior to those who try to cherry pick actively managed funds. You get superior performance with index funds, not average!
Also, comparing D&C Balanced to the S&P500 is like comparing apples and oranges. It's meaningless. The Balanced fund holds a great deal of bonds and its stocks are large value. The S&P500 is all large growth. The comparison is meaningless. I agree that a large growth index should only be a single part of a much larger strategic asset allocation.
I agree you definitely don't want to "handcuff" your manager. You want to get him as far away from your money as possible! If you want international exposure, purchase an international index fund. In the long run, you'll do much better than having an active manager play with your money.
2 cents worth...
JC
The problem is that nobody can reliably pick the S&P500 beating actively managed fund. The average actively managed fund underperforms relevant asset class indexes.
In hindsight you compared D&C to an index that it beat. Here's the Fidelity Composit Index:
9.45 8.81 5.02 9.71
The excessive gains are more modest.
On average the managed composite funds will fall below this index. You're BETTING that you know which ones won't.
I avoid that bet.
Greg
Hi All,
I just want to give the OP a lot of credit for being at the latter end of his investing career, but still being willing to buck conventional wisdom and take healthy risks.
best,
JH
Hi James, if by OP you are referring to me, mutual funds represent only a portion of my assets. And yes they are the risker side of my portfolio.
I also have significant holdings in fixed income. Overall the biggest risk I face is underperforming inflation.
Thanks for joining in. 1stMill
,
