Along with diversification and asset allocation, the third aspect of the Robinswood Financial investment strategy makes use of DFA institutional asset class funds and Vanguard index funds to build the portfolio we think will best help you achieve your goals. We might also use other no-load mutual funds and electronically traded funds (ETF) to further diversify and protect your portfolio.
How Do Index Funds Work?
Most investors see the market as representing the average rate of return. The historic research shown in part by S&P Dow Jones Indices
, illustrates the recurring underperformance of the majority (80 percent on average)
The market is not the average;
the market is the top 20 percent.
of the mutual funds a majority of the time. The conclusion is that the market is not the average, but rather represents the to 20% of market performance.
To be part of that top 20 percent, you can invest in index funds. An index fund is a type of mutual fund
that follows one of the stock market indexes
, for example, the Dow Jones Industrial Average or S&P 500. Essentially, an index fund that follows the S&P 500 actually contains all the stocks that are members of the S&P 500 index.
The concept behind investing in index funds is that you can’t really beat the market, so you might as well join it. This is the basis of an investing theory called the efficient market hypothesis
Why Are Index Funds Better?
We believe that investing in index funds is advantageous because they:
- Reduce your expenses because you’re not constantly buying and selling.
- Closely match the risks and returns of the investment category they represent.
- Often result in higher returns than the majority of other funds in similar categories.
- Allow you to remain always fully invested because there isn’t the internal buying and selling.
- Result in lower tax consequences because of minimal internal buying and selling.
The use of index funds in your portfolio puts into practice the concept of passive investing
. Because an index fund contains the same securities as the market it’s
Index funds often result in higher returns than most other funds in similar categories.
based on—for example, the S&P 500—there is no need for a fund manager to continually buy and sell securities within the fund.
Passive investing is contrasted with active investing
, in which a fund manager buys and sells what are hoped to be the "right" stocks at what is hoped to be the "right" time.
Keep in mind, however, that "passive investing" does not mean passive financial advisors. Your financial advisor reviews your portfolio carefully each month, makes adjustments to take advantage of a continually changing investment landscape, and periodically rebalances your portfolio to correct the inevitable drifts in your asset allocation. Read more about how your portfolio evolves over time
Index Funds Provide Lower Costs and Higher Returns
There are two ways in which index funds reduce your cost of investing. First, index funds have much lower operating expenses, with typical expense ratios around 0.2 to 0.5 percent. Compare this with the 1.3 to 2.5 percent expense ratios typically charged for actively managed funds.
Secondly, the index funds used by Robinswood Financial are no-load
or load-waived mutual funds, meaning you do not pay sales, marketing, and research costs that otherwise eat away at your earnings.
Over the short term, some mutual funds can outperform the market. But picking such funds out of the thousands that exist is extremely difficult. In addition, the costs in most mutual funds make it difficult to outperform an index fund over the long term. When you look at mutual fund performance over the long term, you see a trend of actively managed funds consistently underperforming the S&P 500 index.
Institutional Asset Class Mutual Funds
Robinswood Financial often uses institutional asset class mutual funds to further diversify your portfolio within each asset class. Institutional asset class mutual funds have lower overall operating costs because of the volume purchased by the fund manager of the investing institution. We believe that institutional asset class funds are advantageous to most clients because they:
- Reduce your risks, expenses, and taxes.
- Improve your diversification.
- Place fewer restrictions on transfers.
- Have more predictable risks and returns.
- Keep you in control of your own asset mix, reducing asset class "drift."
Mutual Fund Basics
A mutual fund is an investment vehicle in which multiple investors pool their money so that they can all participate in a portfolio of multiple securities. The investor does not own the individual securities but rather owns shares of the mutual fund. In this way, a mutual fund allows you to have diversified and professionally managed investments without investing a great deal of money. The right mutual funds can provide risk reduction, good performance, ease
Mutual funds are one of the best investment vehicles available.
of purchase and redemption, and simple recordkeeping.
Because of these advantages, mutual funds are one of the best investment vehicles available. By owning shares of multiple companies, the fund's share value is not devastated by the poor performance of an individual company. Of course, the impact on fund share value due to the success of an individual company is also cushioned, but the bottom line is that the built-in diversification helps to reduce risk.
Each mutual fund is managed by the fund manager or management team. These individuals select which securities to include in the fund and they determine the allocation of cash and securities. In addition, they decide on the timing of purchases and sales. The fund manager has the resources, time, and training to make well-informed investment decisions according to their individual style, skill, and experience.
Load vs. No-Load Mutual Funds
A load fund is a mutual fund for which you pay a sales charge, typically between 3 and 7 percent of the full purchase price. For example, if you decide to invest $10,000 in a load fund with a 5 percent sales charge, only $9,500 is actually invested in the fund. The idea is that you would make up what you paid in commissions with the higher investment returns that the fund managers will provide through the load fund.
A no-load fund is a mutual fund that does not include such a commission or sales charge. The shares of the mutual
No-load funds generally perform as well as, or better than, load funds—but without the additional expense.
fund are distributed directly by the investment company, and in our case, accessed through our custodian, Charles Schwab. The idea here is that all the money you invest is working for you in the fund.
While the debate continues, most studies have shown that no-load funds generally perform as well as, or better than, load funds—but without the additional expense. So while salespeople in the financial services industry may say you need to pay more to get more, the correct answer is actually the opposite. If you pay less, you are likely to get more. Remember the old adage: if you watch your pennies, your dollars will take care of themselves.
In a study published in the Summer 2000 issue of the Journal of Financial and Strategic Decisions
, researchers evaluated the performance between 1983 and 1997 of a large sample of 8,100 load and no-load equity (stock) funds. They found that the only time when load funds significantly outperformed no-load funds was 1993. In the other years, there was either no significant difference between the two, or the no-load funds significantly outperformed the load funds.
Active vs. Passive Investing
Most mutual funds are actively managed by a fund manager who picks stocks and times the market to buy and sell those stocks at the right time. The concept is that the talent, experience, and hard work of the fund manager in stock picking and market timing result in the mutual fund providing higher returns than the market. Because actively managed funds require more research and higher volumes of trading, their expenses are higher. Studies have shown that actively managed funds often lead to inferior portfolio returns, especially after the sales loads and annual operating expenses are deducted.
Index funds, by their nature, are passively managed. They contain the same securities as a given market index—for example, the S&P 500, the Russell 2000, or the MSCI World Index. Therefore rather than trying to beat the market, the passive management strategy looks to match the risk and return of the stock market or that particular portion of the market that the index represents. There is no stock picking or market timing because of the index fund’s built-in buy-and-hold approach to investing.
The passively managed index funds are found to be the more reliable road to higher long-term returns. Investors in index funds also enjoy significantly lower investment costs and avoid unnecessary investment taxes.
Efficient Market Hypothesis
A commonly used investment strategy in active management involves timing the market to buy undervalued securities and sell overvalued securities. Individual investors and fund managers assume that the securities they are buying are worth more than the price they’re paying.
The efficient market hypothesis asserts that all markets are efficient and therefore it’s impossible to outperform the market.
Likewise, the securities they’re selling are worth less than the selling price.
Counter to this strategy is the efficient market hypothesis. This is an investing theory that asserts that all markets are efficient. Therefore it’s not possible for investors to consistently outperform the market, because all known information that might affect a stock’s price is already incorporated within its price.
The efficient market hypothesis drives the passive investment strategy on which index funds are based. The efficient market hypothesis was developed by Eugene Fama at the University of Chicago in the early 1960s.
Read more about the efficient market hypothesis: