One of the best arguments for an S&P 500 index fund is that it beats most fund managers most of the time and the fees are usually close to zero. However, the S&P 500 basically is the market so it cannot grow faster than the economy in the long-run. If you can live with a long-run return that approximates the long-run growth of the economy (about 3%) plus inflation (about 2%), an S&P 500 index fund may be just what you need. If that is not enough, you may need a different investment strategy.
Straight talk about index funds. Shutterstock
It is true that the S&P 500 beats most fund mangers. S&P publishes an analysis of the S&P Indexes vs Active Managers (SPIVA) online. Right now they say that only 15.77% of funds outperformed the S&P 500 over the past 5 years. The fact that the vast majority of mutual funds do worse than the S&P 500 over a five-year period is often used to justify investing in an S&P 500 index fund. So many people find this argument compelling, that its worth taking a closer look.
Lets start by asking three questions.
Question: Would you expect a large group of funds to outperform the S&P 500 over five years?
Answer: No. The SPIVA website says more than 10,000 funds were included in their study. With such a large group it is likely that their aggregate holdings will approximate the market which is also what the S&P 500 approximates. That’s why the average return (before fees) of a large group of funds is about the same as the S&P 500. If most of the funds charge a fee, then the average fund would underperform the S&P 500.
Consequently, one of SPIVA’s headline conclusions, that 85% of funds underperformed the S&P 500 over five years, is not surprising.
Question: Does that mean the S&P 500 index fund is a better choice than any fund?
Answer: No. Many people use SPIVA to support that conclusion, but because of the way SPIVA is designed, one can only say that the S&P 500 is a better choice than the average fund, a large group of funds, or a randomly selected fund. These are straw man investment strategies because no one recommends them.
Most people want to invest in funds that have skilled managers. The S&P analysis does not answer the question of whether the S&P 500 is a better choice than a fund with a skilled manager.
Question: When does it make sense to choose a fund instead of an S&P 500 index fund?