A flurry of concern has erupted over the rise of index-fund investing, a strategy I have advocated for years. The main reason for the worry is recognition that three firms — Vanguard, BlackRock and State Street — dominate the business, managing some 80% of all indexed money.
Indexing has dramatically changed the way Americans invest, and for the better. Putting money into a portfolio that matches the performance of an index like the S&P 500 is cheap, simple and savvy. Investors in equity-index funds consistently outperform most professional stock pickers. Yet when index funds were introduced on Wall Street in the early 1970s the notion of pursuing an average rather than hiring a high-priced stock picker to beat the market was considered heretical. Since those pioneering years the evidence has accumulated that the basic idea is right. Businessweek points out that only 10% of actively managed U.S. large-company equity funds outperformed the market in the 15 years through June 2019. Little wonder investors are shifting huge sums away from active managers and into passive investments.
The rise of passive investing threatens the livelihood of many active money managers. Worries over whether a handful of index-fund managers will gain too much boardroom power thanks to their vast holdings of voting stock is an open question well worth exploring, even though many of the risks highlighted in the scarier scenarios lie far in the future (and may not come to pass).
That said, for individual investors saving for long-term goals like retirement, they should continue to embrace investing in broad-based, low-fee index funds (both equity and bond). The strategy is much better than investing with higher-fee actively managed funds.
Remember, the essence of investing is uncertainty. How confident are you about the trajectory of the stock market over the coming year, let alone the next 10 years? Knowing that surprise is inevitable with markets, passive investing offers two big advantages. Index funds are cheap to own. The average expense ratio of equity-index mutual funds was 0.08% in 2018, according to the Investment Company Institute. The average expense ratio for actively managed equity-mutual funds was 0.76%. The passive investment approach is also tax efficient compared with the typical actively managed fund.
Controversies aside, investing in broad-based low-fee index funds remains a good deal for individual savers.
Chris Farrell is senior economics contributor, “Marketplace,” and commentator, Minnesota Public Radio.