John Bogle, the father of index investing and founder of the Vanguard Group, revolutionized the investment industry when his company rolled out the world’s first index mutual fund in 1976.
Since then, these passive investment vehicles have steadily grown in popularity, largely due to their consistent returns and low expenses compared to actively managed funds. Rather than seeking to outperform the market as a whole, index funds passively track a market index to match its returns.
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But the savings associated with investing in index funds over active funds is overstated, according to Morningstar Vice President of Research John Rekenthaler. He argues the real value of index funds lies in their simplicity.
“They require much less research than actively managed funds,” Rekenthaler wrote in a recent column on Morningstar.com. “Finding them is straightforward, as is monitoring their results. Index funds don’t perform inexplicably, forcing shareholders to ascertain why. Nor is it cause for concern when their portfolio managers depart.”
For Rekenthaler, index funds belong in retirement portfolios not because of their lower costs, but their convenience.
Active vs. Passive Management
Before examining Rekenthaler’s recent research, it’s important to review what sets index funds apart from other funds: passive management.
An actively managed fund has a designated professional or group of professionals who preside over the fund and decide how to invest its assets. Fund managers are responsible for implementing specific investing strategies, making trades, reacting to market changes and making other decisions.
An index fund, on the other hand, does not have a professional making trades and decisions related to the fund’s composition. Index funds simply hold the underlying companies and assets that comprise a particular market index, like the Dow Jones Industrial Average or the S&P 500. Passive management not only leads to lower expense ratios, but results in fewer transactions and lighter tax bills for investors.
Why Index Funds Actually Belong in Your Portfolio
Pointing to a 2014 paper in which Bogle explored the “all-in” expenses associated with active funds and index funds, Rekenthaler argued that the gap between the two is actually less than what Bogle initially believed.
When expense ratios, trading costs, “cash drags” and ongoing advisory fees of actively managed funds are added up, Bogle estimated that an investor pays an average of 2.27% for active management, including 1.12% in expense ratios. (Cash drags refer to the opportunity costs associated with the larger cash positions of active funds.) Meanwhile, Bogle found that index investors paid just 0.06% for their investments.
“Such claims were dramatic and highly persuasive. However, they did require an asterisk,” Rekenthaler wrote, noting that Bogle used industry averages. The average expense ratio in his analysis was derived from all mutual funds, regardless of how large or small they were. “What applies for the typical fund does not necessarily hold for the typical investor.”
For example, Rekenthaler noted that half of 401(k) assets are concentrated in large funds with more than $1 billion. Because of their size, these funds typically charge expense ratios that are far less than 1.12%, have lower trading costs and no advisory fees.
The Morningstar executive also compared Vanguard’s cheapest index funds, the Institutional Plus share class, to American Funds’ actively managed R6 shares. The difference in expense ratios is far smaller than what Bogles 2014 research found. While the Vanguard funds have expense ratios of 0.03%, the American Funds’ expense ratios were just 0.35%. “A gap remains, to be sure, but it would take heroic assumptions to give Vanguard’s funds a cost advantage of 1 percentage point per year, never mind 2,” Rekenthaler wrote.
Lower costs are not the primary advantage that index funds have over active funds. Convenience and simplicity is what sets them apart, according to Rekenthaler. Because index funds mimic a broader market, there is little to second guess or question, unlike the decisions made by active managers.
The proof appears to be in the pudding. Despite posting similar alphas between 2011 and 2021, the Vanguard funds grew by $1.17 trillion during that time while the American Funds shares shed $254 billion in assets.
“Add index funds’ undisputed tax advantages … and the verdict is straightforward,” Rekenthaler wrote. “Indexing might well lead to greater wealth. But it is likelier yet to lead to investor satisfaction. And that, ultimately, is what sells.”
Bottom Line
Contrary to the insights of John Bogle, there is less difference today in performance of index and actively managed funds, thanks to the industry’s economies of scale, according to Morningstar’s John Rekenthaler. As a result, convenience is the main reason to opt for index funds over actively managed options. Requiring less research and attention than actively managed funds, index funds are a straightforward investment option, especially for those saving for retirement.
Retirement Tips
- If you’re over 50, the IRS permits you to beef up your retirement accounts with additional contributions. While most savers are only allowed to contribute up to $20,500 to their 401(k) or 403(b) accounts in 2022, those who are 50 and above may contribute an additional $6,500. If you have an IRA and are over 50, you may tack on an additional $1,000 in 2022.
- Planning for retirement is a critical, yet complicated process. A financial advisor can provide advice on asset management, withdrawal strategies and other elements of planning for retirement. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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