Why Index Funds Are Good for New Investors

Why Index Funds Are Good for New Investors

Today I want to talk about mutual funds. I’m often asked, “Hi Shaheeda, should I buy Tesla? Should I sell Target? Is this a good time to invest? What mutual funds are good?”

My answer fluctuates between, “It Depends, No, Yes, It Depends”

No matter how much analysis I do on a stock, my gut instinct always plays a role. Indeed, I review the numbers, and read analyst reports. But the strongest indicator for me to buy is how I assess the future of that company. So, if you believe Tesla has a great future and you are in it for the long run, wait for a dip and buy. I bought and held on to Amazon and Apple stocks when my brokers advised against them. These are 2 of the best investment decisions I have ever made.

In general, I always say don’t sell unless you need the cash immediately. If it’s a dividend stock, always re-invest the dividends and hold. Target had $2.5 Billion in cash and equivalents; $11.4 Billion in long term debt; and spent $18.6 Billion in OPEX as on Jan 2020 on revenues of $78 Billion. They have been paying healthy dividends of 2.64%, so why would you want to sell?

I believe it is always a good time to start investing. As you cannot time the market, it is better to invest small amounts consistently over a long period of time. That brings us to the topic at hand, what mutual funds should one invest in?

Mutual funds or ETF’s are a great way to start investing. I always recommend an index fund like the SPDR S&P 500 ETF Trust (SPY) to start with. Invariably, I always get the question why not any of the other market beating mutual funds?

Mutual Funds can be expensive. Once you add the Fund’s expense ratios plus broker and intermediate fees, you may end up paying anywhere between 1% to 4% on fees alone. I found an article that showed some funds even charge 25%!
Some funds have minimum investment amount ranging from $1,000 to $250,000 or more.
Past performance does not guarantee future success, but you can get a fairly good idea from long term historic performance.

In my previous article, I showed you how remaining invested in the market in an S&P 500 Index Fund is wise in the long term. If you believe in the country or market you want to invest in, then buying shares in a fund indexed to the market is a simple decision.

Why Should You Invest in Index Funds or Index ETF’s?

Several independent researchers have shown that most fund managers do not outperform the market. It is impossible to predict with 100% accuracy how every single stock in the market will perform and therefore be able to always pick and choose the ones that will outperform the market.

So, if you believe that the USA economy will grow and perform over time, then you invest in a USA Market indexed fund such as the SPDR S&P 500 ETF. If you believe the UK market will grow and perform over time, you invest in the FTSE 100 indexed fund. Moreover, the fees for index funds or ETF’s is almost 0%.

Prove It, You Say

I recommend reading Jeffrey Ptak’s article in the Morning Star article, “ How’d Active Funds Do in 2019? So-So”. Some salient points he made are:

“On average, in 2019, successful active funds beat their benchmarks by around 3%, while unsuccessful funds lagged their indexes by about 3.60% last year.”
“Only 40% of actively managed funds beat their benchmark indexes last year (2019)”. This means you have a 60% chance of doing better with your investments if you had passively invested in S&P 500 Index Fund or ETF.
“When you start looking at consistent performance of actively managed funds, the percentages slim down even further. Of the active funds that succeeded in 2019, around 12% had also beaten their benchmarks in 2018 and another 16% had three-peated, outperforming in 2017, 2018, and 2019.” Since mutual funds are long term consistent investment vehicles, it doesn’t give a lot of confidence if past or current performance does not guarantee future performance. So then why should you pay the high fees?

There are nearly 10,000 Mutual Funds in the USA. The chart below shows S&P 500 returns for the past 10 years. 3 out of the 10 years have had negative returns including 2020 naturally. This data is as of May 3 2020.

Bar Chart of S&P 500 Performance over the last 10 years till 2020

If actively managed funds (mutual funds) deserve the fees they are charging, then it follows that they must outperform the market as a whole or the respective benchmark index.

I found this great research by Kiplinger, where they ranked he top 25 All Time best performing funds in the USA. “We looked at the records of all U.S.-listed stock funds – holding U.S. and/or international stocks alike – with at least a 20-year record and ranked them based on returns since inception.”

I’ve summarized their research as below and compared them to the relevant market indices. I am not considering 2020 data for this discussion.

I’ll attempt to walk you through the performance of these all-time great funds against passively investing in an equivalent index fund.

Figure 1

In Figure 1, we compare 2 of Fidelity’s top funds against the S&P 500 Benchmark Indices. You would have done marginally in better to stay invested in S&P 500 than Fidelity’s Magellan Fund in 2019. In fact, even in a 10-year period, you would have done better with a passive investment in the S&P 500 which returned on average 14.15% against Fidelity Magellan Fund. Magellan fund is a great example of why past performance of a fund is not a predictor of the future. Magellan used to consistently return 30% every year during its first 15 years.

However, Fidelity IT fund, consistently outperformed the S&P 500. Over a period of 10 years the Fidelity IT Fund returned over 20% every year, which is nearly 6% above S&P 500 returns in the same period. Even with an expense ratio of 0.72%, this would have been a good fund to invest in. When comparing Fidelity IT Fund to S&P 500 Tech Sector Index, once again Fidelity performed well except when you compare the last 3-year returns. The S&P 500 Tech Sector index outperformed Fidelity on average by 6% in the past 3 years.

Figure 2

Figure 2 compares the Fidelity Growth Fund to both the S&P 500 Index and the Russell 3000 Index, (The Russell 3000 Index is a market-capitalization-weighted equity index maintained by FTSE Russell that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks ). As you can see Fidelity Growth Fund with an expense ratio of 0.83% only does slightly better than either indices.

Figure 3

Returns in Microcap companies (companies with market capitalization of $50 M to $300 M) surprised me. I suppose it’s easier to double $1 to $2 than $1 M to $2 M. Wastach has really shined in these types of investments. Wastach has a hefty fee of 1.66% and requires a $2,000 minimum investment, but their returns in 2019 is a good 11% above that of the S&P 500 and 20% above a comparable Russel Micro Index. So the fund managers have some talent in picking the right stocks. However, over a 5 -10 year period, you can once again see that their performance is only slightly better than the S&P 500. In fact, over the past 5 years they barely made 1% over the S&P 500 returns while charging the hefty 1.66% management fee.

Figure 4

Figure 5

Figures 4 & 5 compares 2 well performing health care managed funds to S&P Healtcare Index as well as the MSCI Healthcare Index. The Fidelity Fund managers seem to have done better than the Vanguard fund managers in the long run. Although Vanguard’s Healthcare Fund had a good return over the last 5 years, they lost the plot in the past 3 years. Although, in 2019, Vanguard Health fund produced a whopping 23% return, it is still eclipsed by the S&P 500 Index returns of 31.49%. Fidelity Healthcare Fund didn’t beat S&P 500 Index in 2019 although it did beat S&P Healthcare Sector Index.

Take Aways

1. Investing is for the long term (5, 10, 20 years)

2. If you are bullish and believe your country’s economy will continue to grow over the long term, then passively investing in a market index fund will generally yield you the same or very close to the same yields as most managed funds with moderate to high costs.

3. Past performance is not a guarantee of future performance when considering mutual funds.

4. Fund houses can have some of the best and worst performing funds. For example, Fidelity, Vanguard etc, have some excellent funds but they also have some very poor performing funds.

5. Invest consistently and over a long period of time.