Why can't an Index Fund beat the market?

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new2bogle2
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Why can't an Index Fund beat the market?

Post by new2bogle2 » Sat Jan 11, 2014 11:58 pm

It is my understanding (but maybe I'm wrong) that a US total stock market index fund will follow the ups and downs of the US market, though it won't out perform the market.

I'm not sure if this is correct but I think a total market index fund contains most all major (but not all) the US Stocks within its fund. And if this is true, then in theory if the stocks not owned in the fund all decrease for the year, the index fund would outperform the total market - do I have the right?

I'm sure it's obvious by this question that I don't fully understand how an index fund like this works so I welcome all who wish to educate me to post below.

MichaelM24
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Re: Why can't an Index Fund beat the market?

Post by MichaelM24 » Sun Jan 12, 2014 12:02 am

I think a total market index fund contains most all major (but not all) the US Stocks within its fund.
For practical purposed it contains them all.

However there are many different index funds made of segments of the market, and those funds can and do beat the total market index from time to time.

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timboktoo
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Re: Why can't an Index Fund beat the market?

Post by timboktoo » Sun Jan 12, 2014 12:03 am

Tracking error can be positive or negative in an index fund, aye.

Texas hold em71
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Re: Why can't an Index Fund beat the market?

Post by Texas hold em71 » Sun Jan 12, 2014 12:06 am

"The market" is generally defined as the stocks in the index. So if the fund owned the funds in the index (or something approximating it ), then the fund matches the market. The main reason you hear that you won't beat the market is all funds have expense ratios so the expenses bring the return to less than the market.

Of course, there is also the problem of tracking error- which is when the fund doesn't quite match the index. Tracking error can work for and against you.

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Re: Why can't an Index Fund beat the market?

Post by magician » Sun Jan 12, 2014 12:08 am

timboktoo wrote:Tracking error can be positive or negative in an index fund, aye.
I think that you mean that the returns of the index fund can be above or below the returns of the index it tracks; i.e., the difference can be positive or negative.

Tracking error is the standard deviation of those differences; it can be positive (or zero), but not negative.

It may be a minor point, but I believe that it's important to use the terminology correctly.
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JoMoney
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Re: Why can't an Index Fund beat the market?

Post by JoMoney » Sun Jan 12, 2014 12:15 am

Vanguard's Institutional class funds have such low expense ratios, and are so efficiently managed, that when combined with the extra income from securities lending they actually beat their index:
Image

Index funds do sometimes sample what stocks they hold from the index, and it is theoretically possible that some major event would happen with one of the stocks not in the index and the fund would have some tracking error, but most individual stocks make up such a small portion of the index it's highly unlikely that it would be a material event that affects the index in a noticeable way... but it is listed as one of the possible "Risks" for an index fund:
https://personal.vanguard.com/us/funds/ ... =INT#tab=2
Index sampling risk: The chance that the securities selected for the fund, in the aggregate, will not provide investment performance matching that of the index. Index sampling risk for the fund should be low.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Why can't an Index Fund beat the market?

Post by MichaelM24 » Sun Jan 12, 2014 12:18 am

The total bond index was beating it's index for a few years until it underperformed by 2% and they had to fix it.

If JoMoney made the above chart with VBMFX you'd see some real tracking error.
Last edited by MichaelM24 on Sun Jan 12, 2014 12:20 am, edited 1 time in total.

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timboktoo
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Re: Why can't an Index Fund beat the market?

Post by timboktoo » Sun Jan 12, 2014 12:18 am

magician wrote:
timboktoo wrote:Tracking error can be positive or negative in an index fund, aye.
I think that you mean that the returns of the index fund can be above or below the returns of the index it tracks; i.e., the difference can be positive or negative.

Tracking error is the standard deviation of those differences; it can be positive (or zero), but not negative.

It may be a minor point, but I believe that it's important to use the terminology correctly.
Thanks. I didn't realize it was a mathematical term. I'll use different words next time :)

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JoMoney
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Re: Why can't an Index Fund beat the market?

Post by JoMoney » Sun Jan 12, 2014 2:57 am

MichaelM24 wrote:The total bond index was beating it's index for a few years until it underperformed by 2% and they had to fix it.

If JoMoney made the above chart with VBMFX you'd see some real tracking error.
I'm guessing you're talking about this (but I don't think it was every really beating the index):
Image
Which I believe is related to what's being discussed here: http://www.bogleheads.org/forum/viewtop ... 6#p1913159

Outside of that serious flub, it seems to track the index fairly well.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Why can't an Index Fund beat the market?

Post by YDNAL » Sun Jan 12, 2014 5:06 am

new2bogle2 wrote:It is my understanding (but maybe I'm wrong) that a US total stock market index fund will follow the ups and downs of the US market, though it won't out perform the market.

I'm not sure if this is correct but I think a total market index fund contains most all major (but not all) the US Stocks within its fund.
An Index Fund contains ALL major Stocks in the Index, but a Fund like the US Total Stock is a *sampling* that may indeed exclude some MINOR Stocks. Can their performance influence the Fund vs. Index comparison, mathematically yes. Realistically, no.
https://personal.vanguard.com/pub/Pdf/s ... 2210077571
Prospectus wrote:The Fund [Vanguard TSM] invests by sampling the Index, meaning that it holds a broadly diversified collection of securities that, in the aggregate, approximates the full Index in terms of key characteristics. These key characteristics include industry weightings and market capitalization, as well as certain financial measures, such as price/earnings ratio and dividend yield.
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Re: Why can't an Index Fund beat the market?

Post by IlliniDave » Sun Jan 12, 2014 7:53 am

As others have said, aside from some relatively small tracking errors and generally small drag due to fund expenses, a good index will closely replicate whatever market or market segment it's linked to. That's the goal of the fund, to replicate the index, whether it goes up or down. Market segments can and will do better or worse at times than the overall market.

This is slightly off-topic, but I've come to believe that "beating the market" has been propped up as sort of a false idol in the investing world. It's become sort of the de facto dividing line between investing success and investing failure, and the vigorous pursuit of it comes with enough drag that the majority of people who try for it wind up noticeably lagging the markets. If one weighs investing success on the impact investing has on their financial life, matching the markets can be a highly successful strategy, and by relative measures can put a person near the top 20% among investors over the long haul. Wall Street doesn't want you to believe such a thing.

That said, I am still guilty of hoping that through prudent rebalancing and careful thought in deploying my ongoing contributions that I might get a wee bit ahead of the weighted average of the asset classes I invest in. But such machinations on my part are small and subtle and unlikely to make a noticeable difference one way or the other. They only amount to my having a small bit of flexibility in the actions I would be taking anyway.
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new2bogle2
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Re: Why can't an Index Fund beat the market?

Post by new2bogle2 » Sun Jan 12, 2014 9:10 am

JoMoney wrote:Vanguard's Institutional class funds have such low expense ratios, and are so efficiently managed, that when combined with the extra income from securities lending they actually beat their index

Can you please explain this part: income from securities lending

Is that something already being done by the vanguard total market index fund? Or is that something I would need to do seperetly?

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Re: Why can't an Index Fund beat the market?

Post by nisiprius » Sun Jan 12, 2014 10:51 am

The goal of an index fund is to track the index. As others have noted, index funds can depart from the index in small ways. Because of expenses, the errors are almost always in the downward direction--earning slightly less than the index--but very rarely you will get small amounts of outperformance, notably in Vanguard's funds.

There is no requirement AFAIK as to how the fund company achieves that goal. In older days they did tend to use sampling techniques but nowadays transaction costs are so low that they can own every stock in the index. Vanguard shows the number of stocks in the fund and in the index for all of their index funds; the small discrepancies are intriguing but I don't know the explanation. You find the numbers under the "Portfolio and Management" tab, e.g.

https://personal.vanguard.com/us/funds/ ... =INT#tab=2

Weirdly enough, in both cases Vanguard says the funds are holding a larger number of stocks than the index. 503 stocks in an S&P 500 fund? No, I have no idea why.

Image
Image

Now, I don't know whether your question concerns chance departures from the index, which as others have shown can occur in both directions, or whether you're searching for some holy grail--an "index fund" that would intentionally beat the market by intentionally excluding some stocks.

A common and bogus criticism of index funds is that they hold all the bad stocks. The implication is that there are surely some stocks that are such obvious total dogs that it wouldn't take genius, just common sense, to leave out the very worst ones. This is seductive but wrong; if a company is lousy, the stock price goes down until it becomes an attractive stock. You can't easily get rich shorting "obviously" bad stocks.

The best proof of this is the failure of the 130/30 funds which were truly a rage just a few years ago, circa 2007. These were actively managed funds, but the thing that made them so revolutionary and exciting was that they held a mixture of long positions on "good" stocks and short positions on "bad" stocks. At one point there were confident predictions that they would soon have $2 trillion in assets and more or less displace traditional mutual funds. Yes, really. And they failed so badly and so dreadfully that something like half of them vanished and you hear virtually nothing about them any more.

There are indeed products that are intended, in a sense, to resemble "index funds that beat the market." They fall into two broad categories. The mutual fund company DFA is always a topic of spirited discussion here, because it is Vanguard's chief competitor in the general arena of "passive investing." DFA's presentations of their products are... nuanced. People argue about whether they really are passive and what passive means. But, in any case, they do not track any index. They apply complicated and sophisticated screening--such as excluding all utility companies from their small value fund--to bring out claimed "factors" (they would deny that this is stock-picking). They use some kind of strategy for making trades, not making trades when strictly tracking an index would require them to trade, but waiting "patiently" for better opportunities (they would deny that this is market timing).

Does it work? Maybe.

Image

The other category are "fundamental indexes," "enhanced indexes," and others of that ilk. These actually are index funds, but the index is constructed in such as way so as to emphasize, I guess, better stocks, based on earnings or dividends or something, rather than being cap-weighted. That is to say, these are index funds, but the indexes they track are indexes that are supposed to beat the total market index--not just in return but in risk-adjusted return (which is what counts, or should count). Here are some examples of such funds. I think they are all comparable to the S&P 500. In yellow, for comparison, Vanguard 500 Index. Do they work? Hmmmph. Not too convincing to me. The Schwab fund, which follows the much-written-about RAFI Fundamental Indexes, did beat the market, but it also dipped lower in 2008-2009, so, more return, but more risk.

Image
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Re: Why can't an Index Fund beat the market?

Post by nisiprius » Sun Jan 12, 2014 1:31 pm

Someone sent me a PM pointing to this posting which explains why the 500 Index can have more than 500 stocks in it. I'm not sure why that person didn't want to post for himself, so I won't give his Bogleheads screen name, but thanks.
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Re: Why can't an Index Fund beat the market?

Post by apex84 » Sun Jan 12, 2014 1:59 pm

new2bogle2 wrote:Can you please explain this part: income from securities lending

Is that something already being done by the vanguard total market index fund? Or is that something I would need to do seperetly?
https://advisors.vanguard.com/VGApp/iip ... iesLending

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Re: Why can't an Index Fund beat the market?

Post by JoMoney » Sun Jan 12, 2014 3:10 pm

new2bogle2 wrote:Can you please explain this part: income from securities lending
Is that something already being done by the vanguard total market index fund? Or is that something I would need to do seperetly?
No, you don't need to do anything. A lot of brokerages as a part of their margin trading agreement would make the investor sign paperwork allowing the broker to lend securities held in the account (but usually don't give any of the proceeds earned from it). Most mutual funds engage in securities lending, but not all of them give the proceeds to the fund (some may give a fraction, others none). For funds that do keep some of the money from securities lending, it potentially creates a conflict of interests as the borrower usually gives cash as collateral while they borrow the securities, the lender can then deposit that cash in other interest bearing accounts. If the managers controlling the lending operations are keeping some of the proceeds they may be inclined to invest in riskier methods to try and earn more interest. Usually its quite minimal, and not something most people are concerned about. There are various laws that restrict how a mutual fund can engage in securities lending.

Usually information about money earned from securities lending can be found in the funds annual report. Other information is in the funds prospectus, and still more in the funds "Statement of Additional Information":
For example, according to the VTSMX annual report, as of the end of 2012 the fund earned: $48,282,000 in securities lending. Considering the fund held net assets of $210,369,657,000 this represents about .022% ... not much, but every little bit counts.

Stocks that are hard to come by can earn more in a lending program (basic supply and demand). Funds with lots of smaller-cap stocks will often earn more than those holding large-caps.
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Re: Why can't an Index Fund beat the market?

Post by Epsilon Delta » Sun Jan 12, 2014 3:35 pm

timboktoo wrote:
magician wrote:
timboktoo wrote:Tracking error can be positive or negative in an index fund, aye.
I think that you mean that the returns of the index fund can be above or below the returns of the index it tracks; i.e., the difference can be positive or negative.

Tracking error is the standard deviation of those differences; it can be positive (or zero), but not negative.

It may be a minor point, but I believe that it's important to use the terminology correctly.
Thanks. I didn't realize it was a mathematical term. I'll use different words next time :)
It is not a mathematical term. Defining tracking error as the standard deviation is similar to defining risk as standard deviation. Different sources will disagree.

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Re: Why can't an Index Fund beat the market?

Post by Sriracha » Sun Jan 12, 2014 4:43 pm

new2bogle2 wrote:It is my understanding (but maybe I'm wrong) that a US total stock market index fund will follow the ups and downs of the US market, though it won't out perform the market.

I'm not sure if this is correct but I think a total market index fund contains most all major (but not all) the US Stocks within its fund. And if this is true, then in theory if the stocks not owned in the fund all decrease for the year, the index fund would outperform the total market - do I have the right?

I'm sure it's obvious by this question that I don't fully understand how an index fund like this works so I welcome all who wish to educate me to post below.
You might be interested in this piece by Bill Bernstein regarding selection skill, transactional skill - http://www.efficientfrontier.com/ef/900/ts.htm. What he discusses certainly shows one big reason why not all index funds are created equally.

Here's a short quote from the article:

"But what if I were to tell you that there is a manager who runs 13 funds, and that over the past 3 years every one of them, adjusting for expenses, has beaten its benchmark? The odds of flipping heads 13 times in succession is one in 8,192, and this in fact understates the odds of this occurring by chance, as frictional costs should lower the odds of a fund's gross return exceeding its benchmark to less than 50-50. Most of you can guess whom I'm talking about: Gus Sauter, who runs Vanguard's index shop."
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