The Future is Uncertain

Investing is rife with uncertainty for the simple reason that the future is uncertain. All other things being equal, the greater the uncertainty (risk), the higher the expected return.  Nevertheless, there are two variables that you, as an investor, can control: 1) how much you invest, and 2) the annual expenses, if any.

 

There is a direct negative correlation between expenses and investment returns: The higher the expenses, the lower the returns. Expenses can take the form of account maintenance fees, transaction costs, commissions, advisor fees, investment fund expenses, etc. Greater investor choice and increased competition have resulted in fee compression, a positive for the investing public.

If you can’t beat ‘em, join ‘em, right?!

Somewhere along the way, though, expense minimization took the forefront as THE most important consideration. Why? Indexing. John Bogle, the late founder of the Vanguard Group and “the father of indexing” pioneered the use of passively-managed index funds that mirror underlying benchmarks. Most active managers cannot consistently beat their respective benchmark net of fees over the long run. If you can’t beat ‘em, join ‘em, right?!

 

Major market indices like the Standard & Poor’s 500 (for US stocks) and the Bloomberg Barclays Aggregate Bond Index (for US investment-grade bonds) are two of the most popular benchmarks. The S&P 500 is an index made up of 500 of the largest US stocks.

 

An investor desiring US stock market exposure could simply opt to buy the S&P 500 index via a low-cost index mutual fund or exchange-traded fund. The least-expensive option has an annual expense ratio (the operating expense of the investment fund) of 0.03%. By comparison, an actively-managed, large-capitalization, US stock fund might have an expense ratio of 1%. For a $100,000 investment would you rather incur $30 or $1,000 in annual fund expenses?

As Mark Twain famously said...

Retirement plan sponsors understand this all too well. Plan sponsors have a fiduciary duty to plan participants. A lackadaisical approach to fulfilling this duty and minimizing fiduciary liability would be to offer all or mostly index funds: low-cost + benchmark-tracking performance. That, ladies and gentlemen, is why your 401(k) investment options are so limited!

 

Index investing is a fine choice for most people, most of the time. It can be used as a foundational component of a well-diversified investment portfolio. It is also a tool for benchmarking performance. But its passivity is a misnomer.

 

When you invest in an index fund, you make an active decision to own the constituents and weightings of the underlying index. In the case of the S&P 500, you own the 500 constituent companies. 500 names imply diversification, but the reality is not that. The S&P 500 is a capitalization-weighted index. The companies with the largest market capitalization (shares outstanding * stock price) have the largest weighting. Currently, the largest 10 stocks comprise over 30% of the index! The majority of these are the “Magnificent 7”: Alphabet, Amazon, Apple, Meta, Microsoft, NVDIA, and Tesla.

 

As Mark Twain famously said, “History doesn’t repeat itself, but it does rhyme.” Remember the “Dot-Com Bubble”?!