Many investors lack the time or the expertise to determine which specific stocks, bonds or other investments they should hold in their portfolio. In addition, they may not have enough money on hand to sufficiently spread out their risk by holding a large number of different securities across sectors, industries and companies.
This spreading out of risk, or diversification, is one of the basic tenets of modern portfolio theory, which holds that you can reduce the risk (volatility) of the overall portfolio by owning a number of securities that tend to move independently of each other. Diversifying, or introducing more securities, helps reduce the overall risk of a portfolio. The fewer securities you hold, the likelier it is that a decline in one of them could adversely affect the whole portfolio; a larger pool of securities tends to spread that risk.
One way to reap the benefits of diversification is through index investing—the practice of investing in a fund with a portfolio of securities that mirrors a particular index.
Index funds let you participate in the growth of the economy in a very straightforward way: The U.S. market has grown over time, so the indexes that follow it have risen in tandem.
Take as an example the Schwab 1000 Index® Fund, which tracks the Schwab 1000 Index, Schwab’s proprietary index comprising the largest 1,000 U.S. companies. Since it commenced operations in 1991, the fund’s share price has grown an average 9.4% annually. Put another way, a hypothetical $10,000 invested in the Schwab 1000 Index Fund at launch and left untouched would be worth almost $80,000 today, as shown in the chart below.
Index investing is a straightforward way to track the market. It is also generally a more tax-efficient approach than actively managed mutual funds. Active funds tend to have higher turnover than index funds—their managers continuously buy and sell securities in an attempt to beat the market, rather than invest according to a set schedule of reconstitution and/or rebalancing. Without that frequent buying and selling, there are fewer occasions to realize capital gains.
Index investing also allows investors to obtain broad exposure to the market even if they do not have large sums to invest.
And finally, there’s cost. The typical index fund has lower operating expenses and management fees than an actively managed fund. The average cost of an actively managed all-equity mutual fund is roughly 0.92% of assets per year.1 Index mutual funds range in cost, but typically charge between 0.10–0.30% of assets. ETFs (which often track an index) range in cost from 0.04% for traditional market-cap exposure, to 0.75% for more esoteric strategies. This gap in fees adds up over the life of an investment. For instance, a $100,000 portfolio growing at 6% annually over 25 years would accumulate almost $58,000 more if the fees were 0.25% instead of 0.90%.
Bottom line, index funds have done well on both an absolute and a relative basis: on an absolute basis over the long term because equity markets have grown over time, and on a relative basis because of their lower cost structures.
How an index works
Index investing often is referred to as passive because index funds track the movements of an index, as opposed to actively managed funds, which have an individual manager choosing investments. While accurate, the word “passive” may suggest a lack of change, and doesn’t fully capture the dynamic nature of index funds. The fact is, index funds follow a rigorous methodology that periodically alters their composition, enabling investors to participate in important market shifts.
To illustrate this point, let’s again consider the Schwab 1000 Index. It screens and ranks all U.S. stocks based on their market capitalization, or the total stock market value of their shares. It builds a portfolio containing the top 1,000 stocks in proportion to their overall value. Then, every year, it rebalances that portfolio to account for stock splits, performance and other corporate actions, and re-ranks the top 1,000, ensuring that investors have exposure to the biggest publicly traded contributors to the U.S. economy. Because the rankings and weightings shift according to each company’s market performance, index fund owners are essentially “making the market their manager.”
Over the course of a year, turnover within the index can translate to the entry and exit of about 50 companies. Over longer periods of time, the index’s annual turnover ensures that the portfolio reflects the changing economy and market. As an example, let’s look at how the composition of the Schwab 1000 Index has shifted since its launch.
One significant change is the dramatic growth of the information technology sector. All told, the tech industry has grown from 10% of the Schwab 1000 Index in 1991, to 18% in 2013. In fact, today the five largest tech companies alone are worth more than $1.5 trillion—the equivalent of about 38% of the entire U.S. stock market back in 1991.2
Long-term market performance
While some individual stock pickers do beat the market each year, data from the Schwab Center for Financial Research illustrates how difficult it is for actively managed funds to deliver outstanding results year after year. Our evaluation shows that between 2004 and 2013, only one equity mutual fund was able to rank in the top performance quartile for more than seven years.
This is not to suggest that active management doesn’t have a place in a well-diversified portfolio—investors just have to devote a lot of time, energy and research to finding the right managers. A good active manager can adopt a more conservative posture in rough markets and play defense. Active managers have greater flexibility in responding to changing market conditions, and some have demonstrated proficiency in protecting portfolios in difficult markets. As such, there is value in identifying active managers who have exhibited better downside protection.
With the increased demand, indexing has evolved beyond the traditional market-capitalization approach to include a number of new and innovative approaches.
Recent innovations in indexing aim to combine the benefits of both traditional indexing and active fund management. One twist is fundamentally weighted indexes, which screen and weight stocks based on a variety of economic factors, such as a company’s adjusted sales, cash flow and dividends plus buybacks.
Fundamental strategies sometimes are referred to as “alternative beta” or “smart beta” because they provide broad-based market exposure (beta), and they weight securities based on fundamental factors rather than simply assigning the greatest weights to the largest capitalized companies.
Fundamentally weighted indexes rely on rules-based disciplines to select and weight securities, removing the potential biases of an active manager who may favor a particular stock because of emotional attachment to the company’s management or a product, for example.
What should investors do?
We believe that active management, market-cap, and fundamental strategies each have their own investment merits, and that they all deserve a place in a well-diversified portfolio:
- Active management offers the potential to outperform a given market, and may be particularly useful for potential downside protection.
- Market-cap index investing offers diversification and cost-effective exposure to virtually every segment of the market.
- Fundamentally weighted strategies capture many of the positive attributes of both traditional market-capitalization indexing and active management, and can add an additional layer of diversification to a portfolio.
1 Investment Company Institute, 2013 Investment Company Fact Book: A Review of Trends and Activities in the U.S. Investment Company Industry.
2According to World Bank, the total U.S. market capitalization in 1991 was $4.0 trillion.