Why Index Funds Are Best for Small-Business Execs
They deliver the most return for the least amount of time
An entrepreneur should hate index funds. They're boring,
unsexy, unoriginal, and passive. They're run on autopilot by hands-off managers.
Instead of making decisions about the best course of action, the managers
merely try to match the overall market's performance. They strive to be
In short, these funds are nothing like an entrepreneur -- which is exactly
why entrepreneurs should make index funds their core holding. An investing
strategy built on index funds is likely to bring higher returns than chasing
after the best actively managed mutual fund -- and to leave you more time
for building the value of your business. In other words, you'll be richer
on both counts.
First, a brief definition. The traditional mutual fund is actively managed
by a portfolio manager or team. They buy and sell stock frequently in attempts
to "beat the market," usually defined by a broad measure such as the Standard
& Poor's 500 index. Index funds are passively managed. Their managers buy
and hold only the stocks contained in their chosen benchmark. Their aim
is to mimic returns, whether the market goes up or down. They sell
only when an investor wants to cash out. Naturally, this saves money on
expensive research, salaries, and other overhead, and it avoids the emotional
traps of buying at the top and selling at the bottom that afflict active
managers. It also keeps your tax bill low by cutting down on capital gains.
In theory, this all leads to higher returns. The big name in the field
is Vanguard's Index 500 fund, which tracks the S&P 500 and now boasts
about $60 billion in assets.
Which kind is better for small-business execs? Let's look at
the odds. There are more than 10,000 funds of all stripes that are tracked
by Morningstar Inc., the mutual fund industry's bible. We dug into its
database and screened all the specialty and sector funds, since it's
too risky to put the bulk of your holdings into one industry.
For the remainder, we calculated the returns to account for sales commissions
-- or loads -- and then compared them to the Vanguard Index 500 fund for
the past 5- and 10-year periods.
The result: Just nine actively managed funds beat the index fund. That's
hardly an inspiring record -- your chances of picking the right ones are
remote at best. And it's especially hard to justify the effort when you
consider how little work it takes to pick an index fund that delivers almost
the same return. Although you certainly won't beat "the market," you'll
beat almost everyone else you know who spends hours sweating over their
RETURN ON INVESTMENT. The second major point in favor of index funds: They
save time -- something that's in perennially short supply for small-business
Think of it in terms of return on investment. Business brokers say an
entrepreneur who buys a company should expect to make 20% to 40% on his
or her money annually, if things go right. By contrast, the returns from
mutual funds in the past three years, during a booming stock market, barely
approached that range. Historically, the stock market's normal return is
closer to 11%. So if building your business is likely to produce
a return that's twice as large, it makes no sense to spend extra time scrabbling
to find the next hot mutual fund for a mere percentage point or
Finally, index funds provide the diversity a small-business owner needs.
As we've pointed out, a small-business owner should have a balanced
portfolio that takes into account the fact that your single biggest asset
is a small, relatively illiquid company that concentrates you in one industry.
Most index funds, by contrast, give you a healthy dollop of large companies
that represent many industries, and the shares of these funds are easily
bought and sold.
What about the idea that actively managed funds are safer than index
funds in a downturn? There's little support for that idea, based on the
most recent downturn. Early data from Morningstar show that S&P
500 index funds dropped more than 10% in the third quarter, but the average
actively managed fund fell even more -- 11.69%.
Which index fund should you pick? Vanguard is the granddaddy in
this business, and its S&P 500 fund is the flagship. The main reason
Vanguard does so well is that its annual expenses are among the lowest
in the industry -- 0.19% of your assets annually. (At the typical
actively managed fund, annual expenses are about 1.5% a year.) It
also offers a broad array of other index funds, including a Total Stock
Market fund that tracks the Wilshire 5000 index.
OVERALL EXPENSES. Recently, competing fund groups Fidelity and USAA have moved in to
match Vanguard's low expenses. But just because some company offers an index
fund doesn't mean it has mastered the art of keeping expenses low. For
instance, expenses at T. Rowe Price Equity Index total 0.40%, but
you're not getting any extra value. After all, they're merely trying to
match the index. And you should never pay a sales charge on an index
fund. This kind of fund is the definition of "no brainer," so you shouldn't
be paying for advice.
How much of your assets belong in an index fund? That's where your financial
planner can help. The answer varies depending on your age, financial
status, and the health of your business. But you don't have to forgo active
investing entirely if you have the itch to play with some of your portfolio.
Gus Sauter, the head of indexing for Vanguard Group, says a conservative
investor who has 50% of assets in bonds should consider putting 30% into
equity index funds and 20% in actively managed stock funds. "With 30% in
that core holding, you can tailor the rest of the portfolio to areas you
think might pay off more," he says.
As we've noted, that's a difficult game to play. But if you can't
resist -- and many risk-embracing entrepreneurs can't -- we'll try to give
you some guidance on what to choose in our next column.
By Rick Green and Timothy Middleton in New York
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