Indexing vs. active management: Which would you recommend in light of the stock market’s recent performance?
By Michael Stone and Jonathan Gerber
The short answer is: Always invest for the long term. “Invest right. Then sleep tight®” is our mantra and guiding principle. Looking back at equity markets over the past 100 years, each time the market falls back, it eventually resumes a steady move forward.
Divide the market into 10-year periods and you will see it has posted positive returns 90 percent of the time. There was also not a single 15-year period in which it did not appreciate.
Sadly, most investors do not take advantage of the market’s natural cycle because they choose active management over strategic, index-based investing. Index-based investing survives bear markets and emerges unscathed—the best way to access equities.
Srikant Dash, global head of Research and Design at Standard & Poor’s, says, “The belief that bear markets strongly favor active management is a myth.” In fact, according to S&P, more than 70 percent of all actively managed U.S. equity mutual funds trailed their benchmarks for the five years ending 2008. “And the bear market of 2000 to 2002 showed similar outcomes,” says Dash.
That is quite explicable when you consider this astounding fact: Portfolios selected by throwing darts routinely outperform the professionals’ selections. While individual stock picking is like looking for a needle in a haystack, with index investing you buy the haystack.
Index-based investing also ensures that investors are exposed to the market’s strong but brief spurts of growth. How brief? Nearly all of the market’s total return over the past 80 years took place in just 37 months. The cost of being out of the market during these surges is almost always far greater than the cost of being in during a cyclical bear market.
Indexing also delivers tax and other savings by removing layers of fees and costs. Active investors pay substantial transaction costs and management fees. Plus, profits tend to get taxed when earned at ordinary income tax rates. Index funds do not bear heavy costs of management. Additionally, fewer transactions mean gains accumulate tax-free over long periods of time and are ultimately taxed at far lower capital gains rates. Investing in an index also reduces the risk that an individual company will fail and impact performance—an important safeguard when one considers that of the 30 companies included in the original Dow Jones, only three exist today.
We have designed a diverse grouping of index funds that combines equities and bonds because bonds are best for shorter-term needs and equities perform well over the longer term. Bonds included are appropriate to your willingness to reduce risk. That combination, teamed with indexing, delivers our ultimate service to clients: long term wealth optimization.
To paraphrase a popular slogan, Rip Van Winkle is all CPAs all the time. Owned, managed and operated exclusively by CPAs, RVW brings an unusual depth of knowledge and understanding that culminates in the three core principles that are at the heart of our practice:
• THE USE OF BONDS IN A PORTFOLIO We use laddered investment grade bonds to provide a greater level of security and lower volatility. The proportion allocated to bonds is primarily determined by the risk tolerance of the individual client. We acquire a diversified group of individual bonds and avoid the use of bond funds.
• THE USE OF INDEX EXCHANGE TRADED FUNDS (ETFS) Index-based investing has been demonstrated to be empirically superior to managed equity investing over the long term.
• COST EFFICIENCY AND TAX EFFICIENCY The use of ETFs avoids the heavy management costs and trading fees normally associated with equity investing. Also, because there are relatively few trades, there are typically very few taxable short-term realized gains. Bonds are bought directly through Schwab Institutional at a dramatically reduced cost to the client.
