1 Keep in mind that an index may also be constructed around bonds and the bond market, or even “road less traveled” asset classes such as commodities or real estate. Today, if you wish, you could literally hold all your wealth in a diversified set of index funds representing asset classes within the United States or the global economy.
2 These accumulations are measured in nominal dollars, with no adjustment for the long-term decline in their buying power, averaging about 3 percent a year since the twentieth century began. If we use real (inflation-adjusted) dollars, the return drops from 9.5 percent to 6.5 percent. As a result, the accumulations of an initial investment of $1 would be $1.88, $3.52, $6.61, $12.42, and $23.31 for the respective periods.
3 “Creative destruction” is the formulation of Joseph E. Schumpeter in Capitalism, Socialism, and Democracy, 1942.
4 To complicate matters just a bit, the Gotrocks family also purchased the new public offerings of securities that were issued each year.
5 But let’s be fair. If we compound that initial $1, not at the nominal return of 9.5 percent but at the real (after-inflation) rate of 6.5 percent, the accumulation grows to $793. But increasing real wealth nearly 800 times over is not to be sneezed at.
6 Changes in interest rates also have an impact, uneven though it may be, on the P/E multiple. So, I’m oversimplifying a bit here.
7 I’m not alone. I don’t know anyone who has done so successfully, or even anyone who knows anyone who has done so. In fact, 70 years of financial research show that no one has done so.
8 William of Occam expressed it more elegantly: “Entities should not be multiplied unnecessarily.” But the point is unmistakable.
9 The S&P Index originally included just 90 companies, rising to 500 in 1957.
10 Well, maybe one comment. Of the 360 equity mutual funds then in existence, only 211 remain.
11 I’ve ignored the hidden opportunity cost that fund investors pay. Most equity funds hold about 5 percent in cash reserves. If stocks earn a 10 percent return and these reserves earn 4 percent, that cost would add another 0.30 percent to the annual cost (5 percent multiplied by the 6 percent differential in earnings).
12 If a $100 million fund earns a return of 30 percent during a given year and $1 billion of its shares are purchased on the final day of the year, the average return earned by its investors would be just 4.9 percent.
13 Estimate of the gap was based on the difference between the 10-year time-weighted returns on the 200 largest mutual funds in 1999 and their actual dollar-weighted returns during the same period.
14 About one-half of all equity mutual fund shares are held by individual investors in fully taxable investment accounts. The other half are held in tax-deferred accounts such as individual retirement accounts (IRAs) and corporate savings, thrift, and profit-sharing plans. If your fund holdings are solely in the latter category, you need not be concerned with the discussion in this chapter.
15 The index fund investor would be subject to taxes on any gains realized when liquidating shares. But for an investor who bequeaths shares to heirs, the cost would be “stepped up” to their market value on date of death and no capital gain would be recognized or taxed.
16 A more-than-technical caveat: due to the issuance of additional shares of stock by corporations over the years, the rate of growth of corporate earnings per share is estimated to lag the growth of aggregate corporate earnings by as much as 2 percentage points per year.
17 The title of a provocative book by Nassim Nicholas Taleb.
18 In fairness, in 2002 Morningstar changed the basis for its rating system to reflect performance versus peers with similar objectives, rather than funds as a group. The relative performance of the four- and five-star funds has improved since then.
19 We’ll never know what would have happened had the contest continued. But the fact is that the Times terminated it at the very peak of the bull market, and at the moment of triumph for the index fund. Since then, the index fund, like the market itself, has barely held its own. While we don’t know whether the advisers would have changed their portfolios, we can calculate how those funds they held in 2000 have since performed. Two advisers did considerably better than the index fund during that subsequent period; one was worse, and one about the same. (The results of the fifth adviser can’t be measured, because two of the funds in his portfolio went out of business.) Despite this all-too-typical reversion to the mean, the index fund maintained its superiority for the full period, with a final profit of $131,800 compared with $117,700 for the fund portfolio of the average adviser, surpassing the results of three of the four remaining advisers.
20 Basically, a Monte Carlo simulation takes all the monthly returns earned by stocks over a long period—even a full century—scrambles them randomly, and then computes the annual rates of return generated by each of the thousands of hypothetical portfolios.
21 I apologize, sort of, for using Vanguard funds for the examples of market indexes. But there are few other bond funds in these categories that implement index or index-like strategies, and literally none with lower costs for individual investors.
22 Early in 2007, 343 ETFs were on the drawing board, soon to be launched. This stampede suggests a new investment fad. Such fads have rarely enhanced the well-being of investors.
23 That is to say, there is no evidence that professional experts earn higher returns than individual amateurs, nor that any class of institutional investor (e.g., pension managers or mutual fund managers) earns more than any other class.
24 Because of space limitations, I deal with each strategy in a cursory manner here. But further study on your part will be rewarded.