Personally, for long term investing goals, I am a huge fan of using an asset allocation approach based on low cost index funds and ETFs.  Fortunately, Mrs. Bootstrap agrees with me on that score.  However, I am also an unapologetic, passionate and dedicated stock picker.  In the interest of furthering my own knowledge (and maybe advancing marital accord as well), I thought I’d investigate what an individual stock picker might learn from an Index Fund?

For those of us who are interested in personal finance and investing (that means you, if you are reading this…), you are probably aware of the copious evidence holding that over the long term (10, 20 years), the majority of mutual funds fail to beat their benchmark.  If you aren’t aware, or are just skeptical, I recommend reading The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William Bernstein (or anything by John Bogle founder of Vanguard Funds).  As an individual investor and stock picker I was interested in seeing why that might be the case and what I might learn from it.  So I decided to compare the granddaddy of index funds – the S&P 500 tracker Vanguard 500 Index – with similar managed large cap funds. 

First, I investigated the component index, from Investopedia.com (S&P’s website was down while writing this):

“An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.”

“Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor's. The S&P 500 is a market value weighted index - each stock's weight in the index is proportionate to its market value.”

I also perused a listing of S&P components as of July 8, 2008.  These range from Exon Mobil at $454 billion market cap (#1) to Dillard’s (#500) at $624 million market cap.

Observation #1 – Stock Selection: as indicated above, the stocks are still picked, albeit by a committee (I’d love to be a fly on the wall as they discussed the inclusion of Dillard’s - as opposed to, say, Bebe).

Observation #2 - Goal: although stocks are picked, the goal is to be a “leading indicator of U.S. equities” i.e. it is meant to match the large cap market, not beat it.

Next, I looked at some of the statistics of VFINX – the index tracker – compared to other large cap funds.  I wanted to compare some operating statistics such as dividend yield, costs, and turnover (amount of buying and selling of individual securities).

Observation #3 - Proliferation: there are a LOT of funds out there!  No wonder everyone is so confused…

Observation #4 - Tenure: although this is a bit anecdotal, there seem to be many fewer funds that actually have a 10 yr performance record.  Most of the research I’ve read indicates that this is survivorship bias – meaning smaller (potentially under performing) funds are closed or merged with larger funds, so only the more successful funds are left open.  Again anecdotally, the funds that I could find that had a longer record do tend to compare well to their benchmark – often exceeding it in the 10 year range.  Presumably, the more scientific researchers have access to data that helps solve for this bias.  Regardless, in a sampling of funds, underperformance at the 10 year mark was not obvious with the results as reported. Any readers that have insight, I’d welcome comments or thoughts.

Observation #5 – Cost: wow!  This is a biggie.  Just looking at the category average, you would pay $110 per year for an investment of $10,000.  VFINX clocks in a much lower $15 per year on a $10,000 investment.  This is assuming you are looking at no-load funds only – fees are even higher if you include a load.

Observation #6 – Turnover: another wow!  The average fund turns over 69% of their portfolio every year; additionally, turnover over 100% is common.  That means that most funds hold their stocks 1.45 years on average and some hold them a year or less.  VFINX on the other hand, has 5% turnover – this means, than on average, they hold a stock for twenty years!

Observation #7 – Yield: this is a bit anecdotal as well, as I don’t have access to a screener that can compare this type of data (suggestions welcome).  But in my random sampling of large cap blend funds, 7 of 10 had lower yield than VFINX.  I’m not sure this is a meaningful observation though as I suspect that some manager styles lean toward dividends and some lean away.  So I suspect on average, it would be, well… average = S&P yield.

OK, so what does this all mean?  Let me try to stitch together some lessons for the individual stock picker – I may have to take some liberties in interpretation, but hey, it’s my blog (and of course, I’d love to hear your feedback if you disagree).  Roughly sequenced to match the observations:

Lesson #1 – Develop a Strategy:  the S&P selection committee has a defined strategy – to be representative of the large cap US equities market.  While I’m sure most investors are trying to “beat” the market, I’m not sure we as often have a well defined strategy.  What are the criteria that you use for selection? How are they applied? When do you modify them?  To hope to be successful, we need to develop a strategy – and the S&P 500 strategy is pretty simple - then we need to stick with it… more on that later. 

Lesson #2 – Have a Goal: Additionally, there is nothing about expected returns in the S&P statement.  I think there is an interesting lesson there as well – the S&P strategy is not, for example, “select large cap stocks that offer potential for total return higher than the Dow Industrial Average.”  Lots of funds seem to have as part of their mission statement to “beat” the S&P 500 over time – then they would have to - otherwise, why would anyone pay extra?  As an individual stock picker, should our goal be to beat the S&P 500?  Should it be to be to purchase stocks with high dividend yields? Low yields for a taxable account?  Regardless of the strategy and goal you select, I would submit, it should not be to beat a benchmark.  Here’s why: even casually perusing fund returns you can see how highly random short term results in the 1, 3 and 5 yr time frames are.  So, are you really going to hold a strategy that you can’t determine is successful until at least 5 yrs?  That seems to be the minimum requirement to determine if you are actually “beating” your benchmark.  However, if your goal is more absolute, then you can measure it better, even if it’s as simple as: select stocks with 15% total return potential per year over a 3 year time horizon.  At least with that strategy, you can measure it in increments in 3 yrs or less.

Lesson #3 – Don’t be afraid to focus: I’ve heard that there are now more mutual funds than individual stocks.  I have no idea if that’s true, but I do know based on researching this post, that it sure seems possible.  This is an area I struggle with a lot.  I read a lot, get tons of different ideas, and want to become an investment expert on every area of the market I read about!  Green Tech, Semiconductors, Oil Production and Development, you name it, I’d love to follow it.  Truth be told, I’m just not expert enough in many of those areas to judge the investment merits of most of these companies.  It’s hard at times, but sometimes better just to say “no”.  I know - it’s an odd lesson to pick up from an index containing 500 names.

Lesson #4 – If you’re in, stay in: clearly, the S&P has a long term focus.  Many funds do not.  To even hope to replicate the index we’re talking a long term game here.  I’m not talking about trading strategy, we’ll get there later, I’m talking commitment to be in the market and stay in the market.  Seriously, what’s the downside?  The stock market may be the only place where it’s OK to be average or even below average. Let’s say, you were an avid stock picker – like me – and for the next 30 years, you invested $500 per month in the stock market.  Then – hopefully not like me – you proceeded to underperform the market by 2% per year.  If the next 30 resemble the last 30, you should see “average” S&P results around 10%.  Even if you were so stubborn as to never throw in the towel (OK, this could be me) and switch to the index fund, you would still end up with $745,000.  Not as good as the $1.13 million you would have with the index, but heck of a lot better than a bank account.

Lesson #5 – Low turnover trading strategy: this comes from Observations #5 & 6.  Clearly costs will add up over the long term, who wouldn’t want the extra $95 per year ($110/yr for the active fund minus $15/yr for the index fund) working for them rather than the fund managers.  Part of the cost associated with the active fund is just making those massive amounts of trades.  Now I lean towards a long term buy-and-hold mentality anyway, and investors who don’t may take exception to this.  But think about an average 20 year holding period.  Heck, I’ll be practically ready for retirement by the time anything I buy today is ready to sell. Just think about that for a second. Twenty years.  Really, when was the last time you made a purchase you made with that level of commitment (stock or anything else for that matter…).  It might affect the decisions you made on what you were purchasing – bought tech stocks, nope holding through the tech bubble, home builders – holding through the crash last year, and banks this year.  It would take amazing stamina and tenacity to hold those through all of the boom and bust cycles that we would see over that time frame.

Sorry, I don’t have any amazing lessons regarding yield.  I know there are some strategies that are focused on high(er) yielding companies.  But honestly, I’m indifferent to dividend.  I love companies that can crank out cash at high rates of return.  Preferably, they’ll invest it in the business for me and I’ll benefit from the amazing compounding that results.  But if they can’t re-invest in the business – I’ll gladly take the money and re-invest it myself elsewhere.

It has been an interesting exercise; I hope you enjoyed it as much as I did.  While I was writing this up, I frequently looked at the S&P index chart from 1950’s through to today.  When you zoom in on any given 5 year period it looks like a pretty harrowing ride; however, if you look at the whole 58 year plot (assuming you are looking on a logarithmic scale) the bumps smooth out and you just see the gentle rise up over the whole time period.  Now, no matter if you index or pick individual stocks, it certainly seems like this is an environment that significantly tilts the odds in your favor.  I’m sure that’s something that both Mrs. Bootstrap and I can agree on!