September 22, 2015

Index Funds Are Nothing Special

An index fund is nothing special. It’s systematic, disciplined, rebalanced occasionally, transparent, low-turnover, low-cost, and low-maintenance. It’s one of the reasons they’re so hard to beat by even brilliant fund managers. You know exactly what you’re getting. Actively managed funds can do all of these things, even if they can’t exactly match the cost structure of an index fund. Instead of worrying about passive versus active, think in terms of disciplined strategies versus undisciplined strategies.
Also, there’s no such thing as passive investing anyways. Indexed investing doesn’t mean you can’t be active, just like investing in active funds doesn’t mean you can’t invest passively. Even those investors that rarely, if ever, make any changes and completely put their portfolio on autopilot have to make some decisions up front. There’s the target asset allocation, the fund types, asset location (tax sheltered or not), rebalancing intervals, and so on. Even the act of not making a decision counts as a decision.
In the future, simple portfolios will be extremely low cost while factor tilts will be cheaper than ever through a combination of competition and scale. Smart beta ETFs are already starting to turn a form of systematic active investing into this same type of process. But low cost and ease of access don’t stop investors from making mistakes. When the cost of a portfolio or a trade becomes a rounding error, it’s much easier to make changes. Emotions become the central component when costs are minimized. Behavior has always been more important than costs, but this will only be magnified as the cost structure falls. The biggest thing for investors is to understand what you own and why you own it.

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