Are index funds doomed?

Meme stocks. Cryptocurrency. Non-fungible tokens. Flashy and controversial trends in investing tend to get the headlines.

So be it. Still, the likelihood is that simple, quiet index investing will only grow in popularity.

Why? Because inertia is a powerful force in any industry, and particularly so if the process or product in question works. “If it ain’t broke, don’t fix it,” as the saying goes.

Let me explain: Quite a few of our clients at Rebalance, at least early on, were what we classified as “brokerage refugees.” They often came to us from a personal financial advisor linked with a prestigious financial institution, but in the dark about their investments.

Why aren’t my investments growing? Am I getting ripped off? What did my parents see in this guy?

That last point is probably the most important. Many people in their 50s and 60s come into money in the form of an inheritance. It might be $50,000 or $500,000, and suddenly it’s theirs to manage.

Often, too, that chunk of unexpected money came with an investment advisor attached, a person with whom a parent, usually the father, had developed a long-running personal relationship.

The problem, of course, is that the traditional brokerage model exists to generate commission income for the stock broker, and not necessarily to grow the account for the client. Seemingly small fees — “it’s just 1%” — turn out to be closer to 1.5% or 2% once you add in fund-level fees and brokerage charges.

Considering the fee burden is on the entire account balance, the truth is that brokerage fees often are a much higher percentage of any given year’s investment returns.

Moreover, the brokerage model only makes money for the stock broker if the client account is traded, so stocks tend to get traded. More fees, more commissions, but not necessarily better performance… usually worse performance.

Own the market

The indexing revolution, as our own Burton Malkiel so aptly explains, came about because there really is no reason to keep trading stocks, other than generating commissions for a stock broker. As it turns out, it’s far better to own the market than to trade it.

Far better for the client, I should note. So brokers grew to hate the low-cost indexing model. Some big financial firms ran toward it but many ran away. Over time, indexing grew dramatically.

So, why do I think it is here to stay? One reason is good old inertia. Young people, over the years to come, will inherit literally trillions of dollars in retirement money held by parents and other relatives.

A huge piece of that money is sitting in index funds, quietly compounding into more money with very little trading necessary. Just rebalancing, really.

I believe that most next generation inheritors will see the wisdom of the low-cost index fund model and stay with it. Rather than inheriting a concentrated collection of stocks and a conflicted financial advisor, they are more likely to use a broad mix of index funds.

They also are likely to inherit accounts that have no advisor attached. They’ll get an 800-number and a website at best.

The thing is, most people could use at least some investment advice. Thoughtful asset allocation, for instance, can make a profound difference in investment return, as can access to timely and intelligent financial planning. Getting conflict-free advice is important.

So indexing really is here to stay, whether the financial industry likes it or not. And that’s a great thing for serious long-term investors. 

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