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Do Index Funds Reduce Investment Risk?

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Index mutual funds and ETFs (we will refer to them as index funds unless otherwise indicated going forward in this article) have received a lot of favorable press of late.  This is justifiable as index funds offer a low cost way to invest and are generally quite specific to a given investment style.  Over the years I have been asked if index funds reduce investment risk.  Let’s examine this question.

Illustration of Standard deviation

What is investment risk? 

One definition of  investment risk as the variability of the investment’s returns also known as standard deviation.   Note variability means returns that are both higher and lower than the fund’s average returns over a given period, say the trailing three or five years.

I contend that most investors would define investment risk as the risk of losing money on an investment.  This is especially true in the wake of the recent financial crises.

An index fund takes on the risk of the underlying index it tries to replicate. For instance, in 2008 the S&P 500 Index lost 37 percent. There are many funds and ETFs that track that index. They all lost around 37 percent plus the fund’s expenses. For example, the Vanguard 500 Index Fund (symbol VFINX) posted a loss of 37.02 percent for the year.

Active management vs. index funds 

Let’s take a look at several of Morningstar’s analyst favorites in the Large Growth style compared with an index fund in this style and with the S&P 500 index.

10 yr. Standard Deviation

10 yr. mean return

Vanguard Growth Index (VIGRX)

+/-15.14%

8.10%

Jensen Quality Growth (JENSX)

+/-13.19%

6.62%

Vanguard Primecap (VPMCX)

+/-15.50%

10.83%

Harbor Capital Apprec. (HACAX)

+/-15.57%

8.65%

S&P 500 Index

+/-14.80%

7.93%

Data from Morningstar.com

In plain English, the Vanguard Primecap fund posted an average annual return of 10.83% over the trailing ten years depicted.  Based on fund’s standard deviation of +/- 15.50% one would expect the fund’s returns to range between -4.67% and +26.33%.

The bigger take away from this chart is that the Vanguard Index fund’s volatility was lower than a couple of the funds and higher than Jensen.   As with any index fund the Vanguard fund experienced approximately the level of risk and return of its underlying index, other actively managed funds in this category experienced more or less risk and return based upon the stock selections of the managers.

Manager Risk 

Index funds can eliminate manager risk, or the risk of investing in an actively managed fund only to see the manager underperform the benchmark index.  As an example for the trailing periods ending January 31, 2013 the Vanguard Growth Index outperformed 83% of the other Large Growth funds for the trailing three years; 84% of the other fund for the trailing five years; and 61% of the other fund for the trailing ten years.

This is not to say this will be the case with all index funds over all periods of time. However, a well-run index fund should track its underlying index closely and deliver index-like performance.

Several years ago an instructor at a continuing education session indicated that many of the actively managed mutual funds atop the 10-year rankings in their respective categories most likely spent three of those calendar years in the bottom quartile of their category rankings. For an investor who held one of these funds over that entire 10-year period this isn’t a problem. But investors who bought into such a fund at a different time or over various periods of time may have had quite a different experience.  As we know, money tends to chase performance, hot funds attract investor dollars, funds that are struggling tend to see more client redemptions.  This is so prevalent that Morningstar measures investor performance along with the actual performance of the mutual fund.  Investor performance provides a measure of how actual investors fared by investing in this fund, including the timing of investments and redemptions.  In many cases investor performance varies significantly from the actual fund returns.

A few other points to consider: 

Expenses matter

You should generally buy the cheapest index fund that tracks the index you are interested in. There is a huge disparity in the fees for funds that track the S&P 500 for example.

Understand the underlying index.

There has been a proliferation of new index ETFs tracking a variety of indexes. In many cases I have never heard of many of these indexes. Make sure the index tracked by the fund or ETF you are considering makes sense for your overall portfolio and that the index has a real history not just some back-tested data behind it.

Using index funds is no guarantee of investment success

Just like with any mutual fund or ETF, how you use these products is the key to your success. Index funds are nothing more than a building block to construct your portfolio.

Don’t dismiss active managers  

Evaluate actively managed funds and understand why they have been successful in the past and in what types of environments they might lag their peers. Moreover, carefully think through the role the fund might play in your portfolio, and be aware of who is managing the fund. Is the same person or team that actually compiled the impressive track record still in charge? Or has this manager moved on, placing the fund in the hands of some new, unproven manager?

Index funds do not necessarily reduce investment risk or guarantee a higher investment return than using actively managed funds.  Like anything in the investment world, investing with a strategy (ideally tied to your financial plan), monitoring your results, rebalancing your allocation, and making adjustments to your portfolio when warranted are still key elements in successful investing.  Index funds are simply a tool you can use in this process.

Feel free to contact me with your investment and financial planning questions.

For you do-it-yourselfers, check out Morningstar.com to analyze your mutual funds and all of your investments and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.

Photo credit: Wikipedia

 

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Comments

  1. Great insight once again Roger. I think that for some that they think being in an index fund means that they are fine and dandy with nothing to worry about when it simply means they’re tracking the chose index. I think they can be a great tool for a beginning investor or someone who simply lacks the time to actively manage their portfolio as a whole. I love that you also pointed out that expenses do matter as that can be easy to overlook for some. I agree too that active funds should not be written off, but thought of in regards to any other investment decision as to how it meets your needs and fits with them.

    • Roger Wohlner says:

      Thanks for your comment John. I generally love index funds and ETFs and would add to your comment that they are an appropriate vehicle for investors of all sizes and types. For example the largest foundation portfolio that I manage has a significant portion of the portfolio in various index funds spread across a number of investment styles. Low cost and style purity (here I’m speaking of your more standard index products not some of the newer ones based on some “funky” indexes) are big pluses. However as you stated the index fund is still as risky as the underlying index and I think there is some confusion in the investing public about this.

  2. Ornella @ Moneylicious says:

    I think investors mistaken risk tolerance. Personally, I am not a fan of the question that ask how likely you are to remain invested if the stock market drops by “x%” it can confuse investors with truly understanding risk in relation to their long term investment horizon.

    I think many people are not aware that many endowments and pension portfolios use index funds to keep costs low.

    Great post on investment risk.

    • Roger Wohlner says:

      Thanks for your comment Ornella. I agree that many investors both do not fully understand investment risk in general or their personal risk tolerance. This is where an investment strategy in the context of an overall financial plan is really helpful.

      As an advisor to pension and foundation clients I can attest that in both cases index funds are used to keep expenses down and frankly for the relative performance they deliver. I like and use active managers as well across my client base, but index funds are often hard to beat.

  3. maurice chia says:

    nice piece. just shared it on my website.

    • Roger Wohlner says:

      Maurice thanks for your comment and your compliment. Please let me know if there are any topics relating to financial planning, investments, and retirement plans that you would like to see written about.

  4. Great summary, Roger. Some funds use the term “volatility” rather than “risk” to describe the propensity to move up and down with wilder swings. The fees should be lower for index fund since it’s just buying a basket of stocks and holding. Wondering if Berkshire is heavily churned, or a completely different animal.

    • Roger Wohlner says:

      Thanks. Good question re Berkshire, I don’t follow individual stocks so I’m not sure of the answer.

  5. Ben says:

    Nice summary. I think one of the biggest risks that index funds reduce is behavioral risk. If you are invested in a broadly diversified set of index funds as opposed to active managers, you won’t play the hot potato game of trying to pick the best manager every year (something many DIY investors try to do and fail). So if they help investors stick with their long-term plan, that’s a huge risk reducer.

    • Roger Wohlner says:

      Thanks for your comment Ben. I agree using index funds can reduce the type of behavior that you described.

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