Practical analysis for investment professionals
23 August 2017

Do Index Fund Portfolios Live Up to Expectations?

Investors are pinning their hopes on index funds.

Almost $500 billion flowed from active to passive funds in the first half of 2017, and index followers have grown to account for more than a third of all assets under management in the US,” writes Bloomberg’s Lukanyo Mnyanda.

But are investors expecting more than index funds can deliver?

Jack Bogle’s mantra that low-cost index funds help ensure that investors receive their fair share of a market’s return, whether good or bad, might be morphing into something very different.

A recent survey by Fidelity noted, “one in five mutual fund buyers believed that stock index funds can protect them from market ups and downs.”

Another survey by Natixis Global Asset Management found that 60% of individual investors said using index funds can help minimize investment losses, and 55% believed index funds provide access to the best investment opportunities in the market.

These misconceptions are likely the halo effect of positive press coverage about the funds’ low costs and relative outperformance. Many investors have not had their newfound faith in indexing tested by a bear market. Further clouding the waters may be a misunderstanding of the implications of mutual fund performance data.

Data from Morningstar’s Active Passive Barometer report showed low-cost index funds have generally outperformed their actively managed counterparts, especially over longer time horizons. Financial advisers and journalists often reference fund data from studies like this when discussing the merits of hypothetical index fund portfolios. But the fact that index funds generally outperform actively managed funds does not mean owning such a portfolio is a surefire way to boost returns, lower risks, or outperform stock-picking fund managers.

The Reality of Index Fund Investor Returns

Higher index fund returns do not always equate to higher returns for index fund investors. Often fund investors, many under the guidance of financial advisers, make important decisions and incur costs at the portfolio level that are not reflected in fund return data.

An investor who owns a few broad, market-cap-weighted index funds must still decide which markets to invest in, how to weight those markets, and when to trade. These decisions are difficult to make in real time and have a significant effect on portfolio returns. Moreover, studies favoring index funds often maintain that costs are one of the most reliable predictors of future performance. The weighted average expense ratio for index funds is about 0.17% versus about 0.75% for active funds. Expenses incurred by investors at the portfolio level — advisory fees, for example — decrease this cost/performance advantage.

Consider data from Candor Capital Management: Eight robo-advisory platforms, all of which generally recommend index fund portfolios, produced a wide range of annual returns, from 5.55% to 10.75%, for portfolios with similar investment objectives. Of course, one year of return data is not enough to judge the merits of one platform over another, but this illustrates how much portfolio returns might vary among index fund investors with similar objectives and expectations.

Managing Expectations

To better manage expectations, advisers should steer conversations away from the investment products — index funds — and toward the investment portfolio. Learning about a client’s past experiences and focusing the discussion on the overall investment process, including the philosophy behind the decision to own index funds, helps to correct misconceptions about what the investor can and cannot control.

Benchmarking is an important but underused tool for advisers when talking about portfolio risk and return expectations. Advisers will use benchmarks to rate the performance of outside fund managers, but almost half do not create benchmarks for the portfolios they are managing. “While 72% of advisors . . . acknowledged that benchmarks are important in client performance reviews, 44% confessed they do not use a benchmark when building client portfolios,” observes BlackRock’s Patrick Nolan, CFA.

Because they view their value proposition as more than what can be measured using traditional portfolio benchmarking, advisers might be hesitant to define benchmarks at the outset of the advisory relationship. For example, Vanguard Advisor’s Alpha says advisers can add meaningful value through wealth management via “financial planning, behavioral coaching, and guidance.” Creating portfolio benchmarks could enhance these services by tying together discussions about investment goals and objectives, asset allocation, risk-and-return expectations, and accountability.

Investors are being inundated with hypothetical performance claims and declarations about the benefits of investing in index funds. But the behavioral risks of such portfolios cannot be measured using the statistical outputs of a backtest. Popular misunderstandings about the benefits of index funds lead investors to underestimate the risks they are taking and may cause them to sell in a panic during the next market swoon.

One rash decision can wipe out many years of investment returns. Advisers need to manage expectations. This means making the difficult transition from product salespeople to investment counselors and focusing portfolio discussions on investment philosophy and process. Benchmarking can facilitate those discussions.

Now is the time for advisers to help investors consider why index funds were created. They are a huge improvement over many of the high-cost investment products currently available.

But they do not exempt investors or advisers from making tough portfolio decisions and being held accountable.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/erhui1979

About the Author(s)
David Allison, CFA, CIPM

David L. Allison, CFA, CIPM, is vice president and founding partner at Allison Investment Management, LLC. He has formal training in investment analysis, portfolio management, and investment performance measuring techniques. He has extensive experience managing investment portfolios for high net-worth investors. Allison is an active member of CFA Institute and the CFA Society of South Carolina, where he is a former president and currently serves on the board of directors. He holds a degree in finance from the University of North Carolina at Wilmington. Advisory services offered through Allison Investment Management, LLC. Securities offered through Triad Advisors, LLC. Member FINRA & SIPC. Allison Investment Management, LLC is a Registered Investment Advisor and is not affiliated with Triad Advisors, LLC.

2 thoughts on “Do Index Fund Portfolios Live Up to Expectations?”

  1. Adam Wright, CFA says:


    Thanks for the links to the Fidelity and Natixis studies. It seemed to me many market participants are assuming index funds are low risk and high return. I was only capturing that from an anecdotal perspective… I am going to look in to the studies a bit further.

  2. American Fool says:

    Index funds are a great tool for building wealth, but like all tools, you have to know how to use them for them to be effective.

    When you look at the massive fund flows into what is called passive funds, largely index funds, mostly Vanguard – it is clear that for some investors it’s merely the flavor of the day. People will abandon these funds too, just as people are mistakenly abandoning minimum volatility now.

    I think a portfolio is like a baseball team. That means players with different skills, each of which may be on a hot streak or a cold one, but in aggregate you are hoping they overbalance the opposition most of the time.

    However, I struggle with benchmarking. Tbh, I kind of band my results. Upper band defaults to the div reinvested S&P500 as a compare point, because if I can match that with less risk over decades (I’m trailing by slightly less than my fund fees, woo hoo!) that’s great performance. I also compare to a static 70/30 portfolio Global Equity/US Bond as a lower band. If I fall below that, then I need to think hard about my portfolio approach.

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