It's Magic! Why Index Funds Come Out Above Average Every Time

The following is a guest post from Mike Piper, author of Oblivious Investing: Building Wealth by Ignoring the Noise. You can also find more of his writing at his similarly titled blog.

To invest in an index fund is to accept average market returns. Yet, strangely enough, decade after decade, low cost index funds beat the majority of actively-managed funds in the same asset class.

Interesting isn’t it? Shoot for average, and you come out above average time after time. It’s like magic.

How the trick works:

Many articles seem to treat the superior returns of index funds as if it’s a coincidence. Or as if it tells us something about the incompetence of active fund managers.

It’s not a coincidence. And it’s not a result of active fund managers being incompetent. (Quite in fact, from what I’ve seen, most active managers are quite intelligent and extremely hard working.)

It’s simple arithmetic. And it works every time: Lower cost = Greater returns.

Let’s say that over a given decade, the stock market earns an 8% return. That means that–before expenses are considered–the average dollar invested in the market must have earned an 8% return as well. Common sense, right?

However, if the average invested dollar incurred 1.5% of investment costs such as brokerage fees, brokerage commissions, and mutual fund expenses, then that means that the average dollar invested in the market only earned a net return of 6.5%. At the same time, any dollar invested in an index fund would have earned very close to the 8% market return. (Somewhere around 7.8%, if we assume an expense ratio of 0.20%.)

In other words: Index funds put you above average.

Three quick notes

First: It’s important to recognize that this holds true regardless of which asset class we’re considering–large stocks, small stocks, all stocks, municipal bonds, corporate bonds, etc.

Second: The advantage of indexing holds true regardless of how the asset class performed over the decade. For example, if the market had earned a -5% return over the decade instead of a positive 8% return, index funds would still come out ahead of the average fully-invested actively managed fund. (They would have earned -5.2% instead of -6.5%.)

Third: Not only do index funds have lower operating expenses than actively managed funds, they have lower portfolio turnover as well. And, despite it’s lack of popularity as a topic of discussion, portfolio turnover leads to expenses that aren’t included in the published expense ratio figures. In other words, the difference in expenses between actively managed funds and index funds is even greater than the published figures would indicate.

Are index funds unbeatable?

In short: No. But they come out above average over every extended period. And frankly, it’s hard for me to think of anything that could give me more confidence than a strategy based upon (as John Bogle says) “the relentless rules of humble arithmetic.”