Index Fund Fundamentals

January 13, 2017

To start the year, let's discuss why it is nearly impossible to beat an index fund over a medium to long period of time. We'll use the United States as an example. The total of the market value of all of the publicly traded businesses in the U.S. on a given day stays roughly the same. Investors own pieces of these businesses, in what we refer to as "stocks." Investors generally are not patient, so they trade their pieces of businesses with others, thinking they can get a better deal, or they know something someone else doesn't. Very smart people all over the world spend their days trying to outsmart each other, often backed up by massive research departments and amazing computer programs. These trades happen hundreds of millions times of a day.

Despite all the trading, the overall value of the businesses hasn't changed. No value has been created, it has just been moved around. Every time one investor "won" by owning a hit like Amazon or Apple, another investor "lost" by not owning it. The problem is that there are all kinds of fees and frictional costs in this system: trading fees, bid/ask spreads, market fees, high-frequency traders front-running trades, mutual fund fees, 12b-1 marketing fees, 401k management fees, too-high advisory fees, manager-of-manager fees, front end and back end load fees, and plenty of taxes on many levels. These fees and taxes significantly wear down the value of what the investor owns. So over time, almost all investors end up with less than average. Most Americans (but not our clients) are participants in this system whether they realize it or not, and their chance of beating the indexes mathematically approximates zero.

An index, on the other hand, does not try to outsmart anyone. An index fund just buys small portions of all of the businesses at once, and removes almost all of the fees, taxes, and error conditions mentioned above. There are plenty of options inside the indexing world on how it does that, and those are arcane topics that Hans and I research and get excited about, but what's important for you to know is that the index "just buys it all."

At One Day In July, we use collections of index funds for clients. Our job is to protect our clients from the fee machine that is the financial industry while exposing them to the capital gains, dividends, and interest that the world's businesses and bonds deliver. And by exposing, I mean the client gets extremely close to 100% of the return.

Dan Cunningham