Why index funds are the optimal place to start

Investing for beginners: Part 4 of 8

In the last article, I showed overwhelming evidence that the average stock picker or trader will underperform the market over the long term. So if we can’t beat the market, wouldn’t the next best thing be to match the market’s performance using index funds?

In the 1960s and 1970s, many academics and practitioners supported the idea of having a fund match the market’s performance. This finally materialised in 1976, when John Bogle founded Vanguard to launch the first mutual index fund to track the performance of the US market. Before diving into index funds, let’s first explore the academic evidence that laid the groundwork for index funds.

We first need to go back to 1952, when Harry Markowitz introduced the idea of Modern Portfolio Theory (MPT). The general concept behind the theory is that for a given level of expected return, investors would like to minimise the variance (or standard deviation) of the portfolio. Likewise, for a given level of variance, investors would like to maximise the expected level of return.

This concept manifests in the image below (image comes from The Wealthy Finn):

Individual assets and portfolios: these include all investable companies in the world as well as every combination of those companies. This also includes assets other than equities, such as gold and bonds.
The efficient frontier: is a curve that contains efficient portfolios. What it means to be efficient is that, by taking any point on the curve, going below the curve means having a lower expected return for the same amount of variance, and going to the right of the curve means having the same expected return for more variance.
Tangency portfolio: an efficient portfolio that has the highest Sharpe ratio, which means having the highest ratio between expected return and variance.
Risk-free rate: a theoretical asset that has zero risk.
Capital allocation line: it is the efficient line that intersects the tangency portfolio and the risk-free rate. This line is efficient because if an investor wants a portfolio that is less risky than the tangency portfolio, then the best way to do this would be to take some combination of the tangency portfolio and the risk-free rate. If an investor wants a portfolio that is more risky than the tangency portfolio, then the best way to do this would be to borrow at the risk-free rate to buy more of the tangency portfolio.

Something interesting this model suggests is that it is almost never efficient to have a portfolio of only a handful of individual companies. This is because of unsystematic risk.

Unsystematic risk (also known as idiosyncratic risk, specific risk, or diversifiable risk) is a type of risk that is specific to an asset or a group of assets. Examples include corporate controversies or a microchip shortage that affects the technology sector. Unsystematic risk differs from systematic risk, which is risk that affects the overall market and is driven by factors such as interest rates, inflation, or geopolitical events.

What makes unsystematic risk inefficient is because it can almost be eliminated through the power of diversification, leaving only systematic risk. That is why instead of only holding a handful of companies, holding thousands of companies across sectors and countries will help minimise unsystematic risk.

To further expand upon MPT, William Sharpe, Jack Treynor, John Lintner, and Jan Mossin all independently developed the Capital Asset Pricing Model (CAPM). A key takeaway from CAPM is that an asset’s price is determined by how much it contributes to the expected return and risk of the market portfolio. Therefore, assuming an efficient market where assets are priced correctly, the market portfolio is the tangency portfolio. A common proxy for the market portfolio is to use index funds to invest in companies at their market-cap (weighting companies based on how big they are).

In conjunction with CAPM, the Efficient Market Hypothesis (EMH), popularised by Eugene Fama’s 1970 paper, hypothesised that asset prices reflect all available information. There are three categories of efficiency the market could be in, although it is believed that the stock market is likely weak-form efficient. Weak-form efficiency suggests that current stock prices reflect information contained in all past prices, implying that charts and technical analysis that rely on past prices alone would be unable to beat the market over the long term. Therefore, the hypothesis would suggest that no group of investors would be able to consistently beat the market using a common investment strategy and that using index funds would be a better strategy (more info here).

With the three models I’ve listed here, note that these are only approximations of the real world. “All models are wrong, but some are useful“. Specifically for the EMH, markets are not perfectly efficient in the real world. However, even if the market is not perfectly efficient, it should still be treated as such. This is because academic research has shown inefficiencies are difficult to consistently exploit after costs.

Malkiel (2003) wrote a short paper in favour of index funds. They noted that over a 10-year period ending 31 December 2001, 71% of actively managed equity funds underperformed the S&P 500, with the median active manager underperforming the market by more than 175 basis points (1.75%). In 1970, there were 355 equity mutual funds holding broadly diversified portfolios. More than half of these funds did not survive over 32 years (likely due to poor performance). Of the remaining 158 funds, only five produced returns that were 2% or more of the market return, showing the extremely low chance of picking a winning fund. Moreover, investors cannot rely on a fund’s past performance to determine whether they will be successful, as funds that were ranked in the top 20 for one decade can underperform the market in the next decade.

Now, with all this support for index funds, this isn’t to say that everyone should only use index funds. As Malkiel writes, “And if you do decide to alter your portfolio from market weightings, you can do so with much less risk if your active bets are made around a core portfolio that is broadly indexed.” Hence, index funds are the optimal place to start.

So how does one choose an index fund? I cover this in my next article: Choosing Index Funds for Australians