Index Fund Folly!

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Expert Analysis and Commentary

Index Fund Folly!

Larry Swedroe Apr 06, 2015

“I know it when I see it.” That line is most famously attributed to United States Supreme Court Justice Potter Stewart who, in 1964, was describing his threshold test for obscenity in Jacobellis v. Ohio. That’s also my threshold for what Jane Bryant Quinn humorously called “investment porn.” I know it when I see it. And last month I saw it in a Forbes article authored by contributor Randy Warren of Warren Financial Service.
Warren begins by noting that the S&P 500 was the best-performing index in 2014, which it wasn’t, because the Dow Jones Select REIT Index returned 32.0 percent and far outperformed the S&P 500’s return of 13.7 percent. He then observes that if an investor diversified beyond the S&P 500, that investor underperformed “the market.”

His main point is that, given the S&P 500’s performance last year, many investors may have drawn the wrong conclusion: that the only fund you need to own is an S&P 500 Index fund, and that you don’t need to diversify across asset classes. He called drawing that conclusion “folly.”

And I fully agree. Leaping to that conclusion makes the mistake I call confusing strategy with outcome. In our world where all crystal balls are cloudy, diversification is always the prudent strategy. In fact, it’s called the only free lunch in investing because, done properly, it allows an investor to reduce risk without reducing expected returns.

Unfortunately, Warren then goes on to lead investors down the wrong path. His recommended solution is to “be tactically diversified, not tied to a fixed diversification percentage.”
He adds, “This tactical strategy is different than simply changing your weighting based on your age. Instead it focuses more on attempting to buy assets that have greater value today and sell assets that have already appreciated in the recent past.” Let’s go to our trusty videotape to see if Warren’s advice is supported by the evidence.

Fortunately, there have been many studies on Tactical Asset Allocation (TAA) funds, all showing the same results — poor and inconsistent returns. In other words, TAA funds are really just another way for mutual funds to charge high fees and lower investor returns. I first wrote about these funds in my 2002 book, Rational Investing in Irrational Times. I cited a study that found, for the 12-year period ending 1997, the S&P 500 rose 734 percent on a total return basis while the average equity fund earned returns of just 589 percent. The average return for 186 TAA funds, however, came in at a mere 384 percent, or about half the return of the S&P 500 Index.

We also have Morningstar to thank for its series of studies on TAA funds. Their first study examined the returns of 163 TAA funds covering the period ending July 2010. That study found that TAA funds generally failed to deliver better risk-adjusted returns, or downside protection, than a traditional balanced index portfolio split 60/40 between stocks and bonds, respectively.

For example, 64 of the 92 TAA funds that were at least a year old (or 70 percent) posted worse since-inception performance than Vanguard’s passively managed Balanced Index Fund (VBINX). The average underperformance was 2.6 percentage points per year. And of the 163 tactical mutual fund strategies covered by the period of the study, 39 no longer existed at the end of it (because of merger or liquidation). Funds that perform well don’t disappear. And of the surviving tactical strategies in the peer group, the median life span was just 37 months.

Despite their poor results, TAA funds continued to attract large new inflows. And given the difficult market conditions since their last study, Morningstar decided to update their research through December 2011. They again compared the returns of TAA funds to VBINX. The following is a summary of their conclusions:

  • Very few TAA funds generated better risk-adjusted returns than VBINX.
  • Just nine of the 112 TAA funds in existence over the period from August 2010 through December 2011 had higher Sharpe ratios (a measure of risk-adjusted returns).
  • Only 27 of the funds experienced a smaller maximum drawdown. The majority experienced larger peak-to-trough declines.
  • Only 14 of the 81 tactical funds in existence since October 2007 posted lower maximum drawdowns during the 2008 financial crisis, the spring/summer 2010 correction and the recent European debt-related downtown. Put another way, just 17 percent of them consistently provided the insurance investors were paying for.
  • In a simulation of the performance of various hypothetical portfolios over the 10-year period ending December 2011, the average TAA fund would have provided very little in the way of incremental diversification.
  • Morningstar updated the study again in 2013. Once again, most TAA funds failed to live up to their promise to limit downside losses and participate meaningfully in any upside.
  • The 2013 update found that, over the 18 months ending June 30, 2013, only 28 of the 142 funds (or 20 percent) Morningstar tracked produced a higher return than the Vanguard Balanced Index Fund.

And finally, Morningstar maintains a Tactical Asset Allocation category that can be compared to a portfolio allocated 60 percent to the S&P 500 Index and 40 percent to the Barclays Aggregate Bond Index. Morningstar reported that, during the three years ended July 2014, the TAA funds had gained an annual average of 7.8 percent, or 3.8 percentage points per year behind their benchmarks.

Bottom line: big fees, poor results. It’s just another game where the winners are the product purveyors, not the investors. Articles like Warren’s entice investors with the hype and hope of outperformance. Unfortunately, the evidence demonstrates that the far greater likelihood is underperformance.

That’s why Charles Ellis called active management a loser’s game. It’s possible to win, but the odds of doing so are so poor that it’s not prudent to try. And, as presented in my new book co-authored with Andrew Berkin, The Incredible Shrinking Alpha, the odds of winning have been persistently shrinking over the 17 years since Ellis’s book, Winning the Loser’s Game, was published.

Passive Management

For investors that know their crystal balls are always cloudy, a divergence in returns can provide an opportunity to do what they dream about — buy low and sell high. Investors accomplish this by maintaining discipline and adhering to their investment plan through the tactic known as rebalancing — not by tactically allocating assets like Randy Warren suggests. As the evidence we reviewed demonstrates, that’s a strategy best described as fraught with opportunity.

Today, disciplined rebalancing requires investors to sell (at relatively higher prices) their outperforming U.S. large stocks to buy more of the underperforming U.S. small and value stocks, as well as international stocks (at relatively lower prices).

Unfortunately, behavioral biases prevent most individual investors from taking advantage of this opportunity to rebalance. Instead, most investors chase returns, buying yesterday’s winners and selling yesterday’s losers — not exactly a prescription for investment success.

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