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Indexing Versus Individual Equity Investment


As investors continue to look for  low risk effective investment strategies, actively managed investing versus passive investing remains a frequent topic of debate.
Though active investing – buying and selling commodities continuously in an attempt to leverage the market – has historically provided better returns, passive investing has become very popular in the last 10-15 years. Indexing, or index mutual fund investing, has become particularly popular.
Novice investors may not have an opinion about which approach is better. Many investors, especially first-time or inexperienced investors, simply want to know where the best place to put their investment capital is.
This article will discuss indexing and the likelihood that indexing can beat the market over the long-run. In addition to overviewing indexing and passive investment, this article will also explain the benefits of a passive approach. Read on to learn more.

What Is Indexing?

Indexing refers to index investing. An index mutual fund is constructed to track a particular market index and involves a collective investment pool overseen by the account or financial manager.

This is a form of passive investing that has grown tremendously in popularity in recent times, to the point that buying into an index mutual fund is a very common investment strategy.

Rather than invest in a particular basket of equities and trade those equities continuously, many investors prefer to invest in an index designed to match a popular market. This strategy has been proven to generate returns while significantly lowering management fees.

One example of a market index would be the S&P 500 index, which is comprised of the 500 American companies with the highest market capitalization. An index mutual fund would attempt to reconstitute the index as closely as possible, purchasing equity shares in similar proportions to the benchmark index.

There are almost limitless ways to construct an index. Some indices are constructed to track high-yield dividends, with the Vanguard International High Yield Dividend Index (VIHIX) being one of the biggest and most popular.

Regardless of which equities an index is designed to track, the concept of index investing remains fundamentally the same: invest in a basket of dozens or even hundreds of equities, diversify across multiple market sectors, and keep management or trading fees to an absolute minimum.

What Are the Benefits of Indexing?

Two primary benefits of index investing are that trading fees are greatly reduced and that an investor buys into an exceptionally diverse basket of stocks. These are the most appealing aspects of indexing for many investors.

With that said, there are a number of benefits to indexing:

Better Upside Capture Ratio

Like most passive investment strategies, indexing generally produces a better upside capture ratio. This is because index funds are built to move with the market itself.

When the market is strong, passive investing tends to outperform most actively managed accounts.

Market Performance

Passive investment strategies such as indexing have been in vogue since the current bull market began in 2009. To wit, the very popular Vanguard 500 Index Admiral Fund (VFIAX) has produced double-digit compounding gross returns in this timeframe, with some return rates nearing or surpassing 15%.

This performance has sustained for almost ten years, making a good index mutual fund a very attractive option as a place to park investment capital.

Market Sector Diversity

By investing into an index that tracks a given market, an investor is simultaneously investing in different market sectors such as healthcare, consumer goods, and real estate.

While every index fund doesn’t include offerings from every market sector, index funds generally have more equity diversity than actively managed portfolios. Those in favor of passive investment believe that diversifying across so many market sectors is an excellent way to mitigate risk.

There’s truth and logic to this idea, as it’s very unlikely that sectors such as energy, health care, consumer goods, telecommunications, and utilities will all recede at the same time.

Potential Tax Benefits

For those looking to lower taxes, index funds offer a more tax-friendly alternative to individual equities due to their lower rate of turnover. This means reduced taxes on capital gains.

Potentially Lower Risk

Index funds are constructed with an eye toward steadier, longer-term growth. While in some situations this limits upside, index funds tend to mitigate many of the risk associated with free-wheeling equity trading.

Because most index funds are so greatly diversified and cross so many market sectors, in most cases index funds are inoculated against heavy losses. The likelihood of a complete market collapse is extremely low.

Lastly, index funds tend to outperform the actively managed funds that overwork to beat the market. There’s such a thing as stirring the pot too much, and this is a risk that index funds rarely incur.

On the other hand, actively managed funds can and do incur “manager risk” including overly-aggressive gambles and poor stock selection.

So, to answer the primary question of this article, indexing can (and often does) outperform the market over a long-enough timeline.

But a better question for potential investors would be to ask if the downsides of mutual fund investing make an index fund the best place to put investment capital. These concerns will be addressed next.

What Are the Downsides of Indexing?

While some readers will think that indexing is a no-brainer investment strategy, any form of passive investment will come with a handful of drawbacks. These include the following:

Inability to Capitalize on Down-Market Opportunities

To use a sports analogy, passive investment is taking the ball out of the investor’s hand. One of the biggest benefits of active equity trading is that a shrewd investor or manager can recognize investment opportunities in a down market, and adjust or reinvest accordingly.

If the stock market, on the whole, is down (bear market), not only is the value of an index mutual fund in decline, but index-only investors have also lost an opportunity to capitalize on buy-low market opportunities. This is one way in which active investors can better leverage the market.

Inability to Adjust Portfolio Construction

While most financial analysts and historians agree that the U.S. stock market, on the whole, is efficient over a long-enough timeline, the market can be extremely volatile over the short term.

An advantage that actively managed accounts have over passive accounts is that an active manager can adjust to changes in the market. If an actively managed portfolio is a bit overinvested during a downturn, the portfolio can be recomposed to account for the decline of a certain industry or sector.

Meanwhile, an index fund investor will need to ride the highs and the lows of the market. While this may be fine for people with certain dispositions, this can cause significant stress for investors with low-risk tolerance.

Inability to Time the Market for Better Returns

Timing the market is difficult for non-professionals, and yet another reason why actively managed accounts can produce better returns in the long run.

Seasoned financial professionals can recognize when a market is about to decline and adjust a portfolio to drastically reduce or even mitigate losses.

Whether this means reinvestment in alternative assets such as investment-grade bonds or adjusting portfolio weight to include equities from a different sector, there are many tactics that a good portfolio manager can use to stave off losses – or even generate returns – in a down market.

While passive investors love low management fees, this is one situation in which the cost of a good account manager is well worth it, in both the short-term and the long-term.

Other risks of indexing include rising interest rates, which can stifle the sustained growth of the market, and overly rich equity valuations caused by cap-weighed indices. These are both risks that novice investors may not know about, let alone weigh and consider.

Better Performance in Falling Markets

Morningstar determined in several studies that active investing is a better strategy when the market is falling. Given that the market has been a bull market for quite some time, this is a notion that a novice investor may not have fully considered.

The same data from Morningstar also indicated that many of the fund managers who did well in bear markets were unable to hit the same performance level after the market turned.

This isn’t to say that index fund managers are only succeeding because of the market – quite the opposite, in fact – but the data suggests that some managers perform better during down markets. It would appear that many of those managers gravitate toward active trading.

Indexing Versus Active Management: Which Approach Is Better for You?

As you’ve read, there are merits to both active and passive investment strategies. Passive strategies such as index investing are often preferred by investors who want minimal hassle and don’t enjoy scouring daily market reports.

And while index investing is slightly lower risk and will outperform the market at times – particularly during bull markets – in many cases, an investor could be limiting her or his returns with this approach.

Ultimately, it will come down to an individual investor to decide if participating in an index mutual fund better suits her or his disposition, but history has shown that a smartly managed individual equity portfolio has a better chance of consistently outperforming a down or falling market.


Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Linden Thomas & Company

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At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

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