By Dr. Jim Dahle, WCI FounderIndex funds (both the traditional mutual fund version and the exchange traded fund (ETF) version) are profitable, but only for those who own them. Not necessarily for those who sell them or provide them. The largest traditional index mutual fund provider, Vanguard, is run at cost. Schwab and Fidelity compete with them, but many suspect these two companies use their index funds as loss leaders for other products. State Street (SPDRs) and BlackRock (iShares), along with Vanguard and Schwab, lead this space for the ETF versions. Although these funds are often monstrous and profits “can be made up on volume,” I'm skeptical that there is much profit there given that the expense ratios are so similar to what Vanguard is charging.
The bottom line is that there is very little incentive to do a lot of advertising and other marketing for these products. Vanguard advertises, but it's usually portfolio management services—not the index funds themselves—that are being marketed.
This lack of marketing can sometimes cause investors to not be as aware as they should be of the benefits of index fund investing. Eight-five percent of our portfolio is invested in index and index-like mutual funds. Some of our favorites include:
- Vanguard Total Stock Market Index Fund
- Vanguard Total International Stock Market Index Fund
- Vanguard Small Value Index Fund
- Vanguard FTSE All-World Ex-US Small Cap Fund
- All of the TSP Funds
- Fidelity Zero Total Market Index Fund
- Schwab US TIPS ETF
- Vanguard Intermediate Term Tax Exempt Fund
This is hardly an exhaustive list of top-notch index and index-like investments. There are many other excellent, low-cost, broadly diversified index funds out there.
All of the above funds have low expenses and enjoy low turnover, and they are very passively run. You know what you're getting when you buy it (it's usually in the name), and that will be exactly what is still in it a decade later when you check in on it. In the long run, the performance will beat most, but not all, of the actively managed peers for a given fund, especially after-tax. There are at least 10 unsung benefits of index funds, and today's post will discuss them.
#1 Rafting
What? Yes. That's right. Rafting is my No. 1 unsung benefit of index funds.
This is not a picture OF me (I took it), but it is a picture of my raft, my cousin, and my son on the Salmon River. I like rafting. It's a lot of fun. However, it takes a lot of time, requires a fair amount of money, and takes place in locations where one is completely disconnected from the world for 1-3 weeks at a time. It takes very little time to invest in index funds (I did this month's investing chores—two purchases of index ETFs—in about 30 seconds). That allows more time for rafting. The solid returns provide the money to buy expensive rafting equipment. And most importantly, the set-it-and-forget-it nature of index fund investing allows me to forget about my investments for weeks, months, and even years at a time.
So, I can go rafting. And climbing. And canyoneering. And boating. And backpacking. And traveling the world. No need to check in to watch my stocks each morning. No day trading required. No worries about the financial news. No options to roll over. No manager risk to worry about. I can go rafting, and these days, I come home from the trip richer than I left—all thanks to index funds.
More information here:
How Do You Evaluate and Compare Mutual Funds and Exchange Traded Funds?
Vanguard vs. Fidelity — Which Is Best for Your Investments?
#2 Passive Income
Passive income is a buzzword. Everyone wants it, because earned income is, well, work. And most people don't like to work. Not necessarily because they're lazy (although many are), but simply because play is more fun than work. However, most of what is described as passive income is not truly passive. I started a blog once because I wanted passive income. Then, I proceeded to write over 100 blog posts a year for it. Before long. I was working full-time on this business. Then, one day there were 15 other people working on it. Does that sound very passive? Not really. Neither is being a landlord. Writing a book. Doing a podcast. Developing, marketing, and running an online course. Doing online surveys. Even selecting private real estate syndications and funds requires a fair amount of due diligence work. Heck, you've got to sign a bunch of paperwork and wire money at a minimum.
You want passive? Invest in an index fund and then sit back and wait for the dividends to pour in. The yield (not the return, know the difference) on an index fund might only be 2% and you might have been hoping to have income of 4% or 6% or more from your investment. But those dividends are the most passive form of income I know about. It took literally 30 seconds of work 20 years ago, and I'm still getting passive income every quarter. The dividend income from the index funds in our taxable account now exceeds my not terribly impressive clinical income.
#3 No Fraud
Ever been burned by a fraudster? I have. If you invest for long enough outside of the publicly traded security markets, it will probably happen eventually. Diversification is key. It protects you from what you don't know and what you cannot know. But you know where there is very little fraud? Vanguard, Fidelity, Schwab, State Street, and BlackRock. They're huge, closely watched, highly regulated companies, and the investments of an index fund are publicly traded companies that are frequently and carefully audited. Yes, there's an occasional Enron. But there are also 4,000 other companies in the fund. There's no lying awake at night worrying about being Bernie Madoff'd. There's no having to hold on to the investment for four years after it goes bad in hopes that you can get some of your principal back.
More information here:
How This Financially Literate Doctor Got Scammed Out of $75,000
Beware of Pump-and-Dump Schemes
#4 No Manager Risk
You know what the problem with managers is? Some of them suck, and all of them die. This is the case for property managers of your direct income properties, for active mutual fund managers, for private syndication managers, and for financial advisor/investment managers. But you know who doesn't suck and who doesn't die? Computers. They just do what they're told. For decades.
“Guarantee us the return of the CRSP US Total Market Index.” No problem, the computer says. And it does it. Been burned by an incompetent manager? I have. Who knew that you shouldn't finance a long-term asset with short-term debt? Well, everyone knows that. Yet managers still do it. But your computer won't.
#5 Readily Available
I can buy the same index fund in my 401(k), defined benefit/cash balance plan, my other 401(k), my Roth IRA, my HSA, my kid's UTMA, my 529, and my taxable account. Easy peasy. No need to open a self-directed IRA. No need to go directly to the fund provider; it's available at every brokerage. Same investments. Same fees. Same computer manager.
#6 Boring as Heck
My index fund investments are boring. Nobody is interested in hearing about them at a cocktail party. There are no long threads about them on the WCI Forum. Heck, I can only bring myself to write about them once or twice a year on my investing blog. And nobody even comments on those posts. Not until the sixth WCICON did I even give a talk about them. They're real yawners.
However, the truth about investing is that good investing IS boring investing. George Soros famously said:
“If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring.”
John Maynard Keynes said:
“The game of professional investment is intolerably boring and overreacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”
Warren Buffett said:
“Investors should remember that excitement and expenses are their enemies.”
Paul Samuelson remarked:
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
Jack Bogle, widely considered the godfather of index investing, described it this way:
“It is the most boring investment strategy ever invented in the history of time.”
The beautiful thing about my index fund investments is that they're not interesting at all. So, I spend my time with my family, working on my business, helping patients, going rafting, reading a book, and looking at a sunset. You know, the stuff that fills a meaningful life. I'm also not tempted to make any changes (which are likely to hurt me). Since nothing interesting ever happens, I'm not really watching what is happening. I mean, the last time I found any degree of excitement in index fund investing was in October 2008, and that sort of thing just doesn't happen very often. After watching my investments carefully back then (when they went up and down 5%-10% per day), everything since has seemed like statistical noise.
#7 Easily Leveraged
Want to use leverage (debt) to try to reach your goals faster? Don't be fooled by those who tell you that you can only use leverage with real estate. Stocks, via index funds, are easily leveraged. You can convert your taxable account to a margin account. You can usually borrow up to 50% of the value of your investments. You can use that money to buy a house, go on a trip, or buy more investments.
While you need to be aware of the possibility of a margin call, this is a quick and easy way to borrow. However, a margin account is hardly the only source of borrowed money. In fact, most of the people reading these words are already investing using borrowed money. That's because money is fungible. If you own an index fund and have a mortgage or if you own an index fund and have student loans or if you own an index fund and have a HELOC, a car loan, or a credit card balance, you're already investing on margin. And without the possibility of that pesky margin call. Go refinance your house and dump the proceeds into an index fund in a taxable account (or even a retirement account assuming you have enough earned income to “cover” that contribution). It's just as easy (maybe easier) than using the borrowed money to buy an investment property.
#8 No Inheritance Fear
My wife and I had an interesting discussion recently. I asked her how many private syndications she wanted to own after I died. Guess what the answer was? That's right. Zero. You should ask your spouse similar questions from time to time. You may be very comfortable with investment properties, syndications, private real estate funds, hedge funds, cryptoassets, and a few side businesses. But your spouse, kids, favorite charities, other heirs, and their financial advisors, accountants, and attorneys do not feel the same way. They want easily understood investments. They want investments that are easily liquidated.
Some spouses are still terrified to have to run a portfolio of index funds in the event of your death. There's not much I can do for them outside of hooking them up with a good advisor. But almost all of them are terrified to run a hodgepodge of private investments. That problem is easily solved.
It's not even just your heirs you need to watch out for either. Your own mental capacity will likely decrease throughout retirement—sometimes quite alarmingly in a rapid manner—all while you're managing the largest amount of money you've ever had in your life. You can either pay a trusted professional, or you can keep it simple and protect against your own senility.
More information here:
#9 Saved Advisory Fees
I often run into an investor whose advisor has placed them into 20, 30, or more mutual funds and individual stocks. Many years ago, I rescued my parents from a similar advisor. It was actually an easy sell. I simply calculated their portfolio performance and showed them what it would have been had they been invested in a couple of index funds instead. However, the real tragedy was the fact that they were paying 2% a year to this advisor to perform that “service” for them. Even if your portfolio of index funds merely matches the performance of a frenetic, hyperactive manager, you still get to save 1%-2% a year because managing a portfolio of index funds is so easy for a DIYer that you don't even need the advisor to do it for you.
Listen, if you want an advisor, I'll find a good one for you. I can probably even help you get one that will charge you much less. But most investors are much more comfortable being a DIYer with index funds than any other investment. The truth about financial advisors is that the real value is in the financial planning anyway, not the investment management.
#10 Tax Simplicity
You probably already know about how index funds are very tax-efficient due to their low turnover. This is particularly the case at Vanguard with its ETF share classes that flush out capital gains. But what you might not appreciate is the tax simplicity that results from a buy-and-hold strategy of index funds.
Inside retirement accounts, there are no tax consequences whatsoever from index funds. Even with a taxable account, you are simply sent a consolidated 1099 at the end of January each year with a handful of transactions on it. They can even be automatically imported from the brokerage into your tax software, making DIY tax preparation a breeze. Compare that to an investment like direct real estate, where you'll be filling out all kinds of information on Schedule E. Or worse, a multi-state private real estate fund that now requires you to file taxes in a dozen states. That sort of tax complexity will drive even a hardcore DIY tax preparer into the arms of an accountant, resulting in thousands of dollars of tax preparation fees.
You've heard previously about the strong performance, low fees, tax-efficiency, and broad diversification of index funds. But you may not have considered the unsung benefits of these excellent investments.
What do you think? Do you invest in index funds? Why or why not? What is your favorite unsung benefit?
These reasons explain the growing popularity of passive index investing.
It has taken longer than I thought.
I didn’t explain this well when my med school roommate asked me in 1990, “Why are you ok with average returns by buying the whole market like that?” I should have given all these reasons. I still have no regrets about 35+ years of low-cost, passive index investing.
Jim, great post, I think this list needs to include compliance benefit considerations with legal, employee code of conduct, and ethical considerations. Perhaps that is more in contrast to individual stock investing than mutual funds generally. That may need some special focus for WCI folks with IP interests.
Great point! That should be added to the list. It’s so unsung I didn’t even think of it.
One other benefit I have experienced is a sense of peace, at least for equity investments in VTI and VXUS given their nature. I suppose also in light of all of the other stupid stuff I have done. It might fit within #6 boring as heck, perhaps as the half full part of it. Best I can articulate is it feels more like a share of the ownership of investment property in everything public everywhere and is the polar opposite of the adverse spiritual aspects of gambling and envy.
You can still have a long discussion about index funds — whether to buy small cap value or how much international ? You are right the majority of people find it super boring but for the small minority of the population (who are on bogleheads) these topics can lead to thousands of posts and hundreds of hours of reading.
Sure, thousands of hours of reading. And at the end you realize that there is no right answer and you just need to decide what is right for you and stick with it.
That sounds like a great idea for a post if you haven’t explicitly written it yet. 5 to 10 things that are uncontroversial and evidence based and that most reasonable people agree on. (e.g. low cost, tax efficient broad market index funds). And 5 to 10 things that are ambiguous and controversial with reasonable people taking opposite sides (e.g. what % of portfolio to put in domestic vs international). Way too much time seems to be spent on the latter.
Another often overlooked benefit of investing in mutual funds is the ease in which they can be inherited by the next generation. They typically can be inherited in kind with a simple phone call to Vanguard or Fidelity.
What are your thoughts about direct indexing, particularly for large (multi-million dollar) portfolios? Although admittedly far more complicated, it allows you to tax-loss harvest more effectively. Perhaps more importantly for those of us with a charitable bent, you can donate appreciated shares of one component of the index to a DAF and immediately purchase new shares to reset the basis cost.
https://www.whitecoatinvestor.com/what-is-direct-indexing/
You mention the TSP funds which it seems have slightly higher expense ratios than Vanguard funds. This difference could be meaningful over the long term. We have been considering whether to rollover our TSP balance to Vanguard or Fidelity (consolidating with other retirement assets.) Is it worth the effort and concern that we may be subject to losses if we have an unfortunate alignment with the market while the assets are out of the market during the transfer process?
No. The difference is NOT meaningful over the long term. It wasn’t very many years ago that the TSP had MUCH lower ERs than Vanguard funds either. More info here:
https://www.whitecoatinvestor.com/expense-ratios/
TSP, Fidelity, Schwab, Vanguard, iShares index funds all are basically free these days. There is no meaningful difference between their ERs and 0%.
Do people really buy whole stock market index funds on margin? I feel like outside of another crash you would never get margin called and if your portfolio is big enough and you don’t overleverage yourself you will essentially make free money minus fees/interest of buying on margin. Is that true? What am I missing>
Great question and observation. People talk about market risk and small and value risk all the time, but leverage risk gets left out of the discussion way too much in my experience. That said, it has to be managed well like any other risk and if you don’t need to take it to reach your goals, you shouldn’t take it.
https://www.whitecoatinvestor.com/use-debt-to-your-advantage/
https://www.whitecoatinvestor.com/how-to-think-about-debt/
That said, it’s not “free money.” There IS additional risk.
WHat is the typical borrowing rate?
Typically most brokers have retail margin rates for small investors that will likely exceed the expected return in all but the most bull markets. I checked a couple lately and for small investors this is currently running 13%+ (I understand the expected return of a balanced portfolio should be around 5-7% per year over the long term.)
My understanding is you need a portfolio worth likely into the many millions before you can get low enough interest rates that make the arbitrage profitable (and also facilitate things like “buy, borrow and die”).
That wasn’t the case just a few years ago at Interactive Brokers. I think I saw margin rates as low as 2% at one point.
I find broad stock index funds get a little less boring to newbie investors when you show the steadily declining (better) quartile performance over time in trailing returns on Morningstar, SPIVA scorecards, etc. It’s always nice to see when the lightbulbs start going on.
Also, you can reap the rewards of high yields paid for holding long term bonds, without being committed to holding them long term. VCLT, BLV
One caveat: The S&P 500, normally considered a broad index, has recently become highly concentrated, with the top 7 stocks making up approximately 30% of the index. These stocks are all related in some way to the “AI Boom” and as such are dependent on “AI” being able to turn millions of expensive chips, and acres of expensive “data farms” into a very large profit in some way. So ETF’s like VOO that track the S&P 500 should be used warily, as this index is no longer as conducive to “Rafting” being “Passive” nor “Boring as Heck.” I note that you don’t list VOO as a favorite. Using VT instead, opens you up to international investing, and drops risk associated with the top 7 about in half, to 15 %. Adding Mid Cap and Small Cap value index funds like VOE and VBR will go further to keep you out of the “Dot AI” frenzy. Unfortunately, I have noted in the past, that if something big and bad happens in the market, pretty much everything (yes, including bonds) will go down along with the culprit, regardless of blame. That’s why we say that “investing in securities involves the risk of loss.”
Like any cap weighted index, the S&P 500 has always been concentrated in top spots. It might be 30% now but I bet the top 7 stocks have never been less than 20%.
Axios has some perspective on the top 10’s influence over time that is interesting in this context: https://www.axios.com/2024/02/05/sp500-magnificent-seven-stock-market
Thanks for sharing. Good find. But it illustrates my point pretty well. It’s never been lower than 18% right? And it has been 40%+ before. So 33% isn’t exactly “hit the panic button” sort of thing.
However, as a small value tilter who now sees what may be the highest historical gap between SV and LG valuations I can’t wait for the pendulum to swing back a bit. But I’ve been saying that for years. The market can stay irrational longer than you can stay solvent, but trees don’t grow to the sky either.
Stay the course. Crystal ball cloudy and all that.
Can you please let me know where I can find the ETF list you have posted?
Thank you for the phenomenal website
What ETF list are you talking about?