A Common Misconception of Index Funds

It is now a well known fact that 80% to 90% (depending on the study) of actively managed funds underperform S&P 500 index funds.  The reason for that is two-fold.  First, active fund managers charge higher fees.  Second, they tend to trade often which results in commission costs, unfavorable capital gains tax treatment, and most importantly, underperformance due to continued attempts to time the market  stemming from frequent trading.  Index funds, on the other hand, change composition very rarely and thus almost never trade.

As a result, there is a flow of cash from actively managed funds to index funds.  Many prominent investors, including Warren Buffett, advocate to consider only index funds for individuals.

However, many investors don’t understand exactly how index funds are structured.  Most indices, including S&P 500 index, are not equal weighted, but instead market capitalization weighted.  This means that dollar amount of each fund holding is proportional to its market cap.  So if you invest $1,000 into S&P 500 index fund, you will not put $2 into each of 500 companies.  Instead, you will own approximately $50 worth of Apple, $30 each of Microsoft, Google and ExxonMobil, etc. — because these are highest market cap companies in the index.  And you will invest only $10 combined into hundreds of mid-cap and smaller companies with less than $5 billion market cap.

While market capitalization is appropriate to measure performance of the overall market, no reasonable investor will construct his or hers individual portfolio in the above manner.  The best way is to select high quality companies with excellent management teams and own these companies for a long time, selling only if business fundamentals deteriorate.  That way, you can have your own properly constructed “index fund”, and without market timing, it will have a good chance of beating the venerable S&P 500.  This is exactly the strategy I use for my clients’ and my personal portfolios.