Here’s One Underappreciated Reason Why Index Funds Have Been So Popular

Investing in index funds have become incredibly popular. While investing used to be all about picking the hot stock or finding the next star fund manager, money is piling into index funds and away from actively-managed mutual funds by the billions.

While there are many clear advantages to index funds over actively-managed mutual funds, I wanted to highlight one underappreciated reason for the sharp increase in money piling into index funds over the past few years.

Why Index Funds Are So Popular

First, let’s discuss the obvious reasons why index funds have become so popular:

Simple, easy diversification

Index funds offer total diversification to an asset class with a single fund. When you purchase a total stock market index fund like VTSAX at Vanguard or FSKAX at Fidelity, you are purchasing more than 3,000 stocks.

By buying an index fund for each of the major asset classes, such as U.S. stocks, international stocks, and U.S. bonds, you can form a diversified portfolio with just three index funds. Investing doesn’t get much easier than that.

Low fees

Index funds have the lowest fees in the entire mutual fund industry. This is because index funds are passive investments — the fund manager focuses only on how to match its underlying index. Active fund managers, on the other hand, need to figure out ways to beat the market. This requires teams of financial analysts, meetings with company executives, and expensive software. As a result, the average stock fund charges 1% of assets under management per year, while the best index funds charge less than 0.1% per year. This difference adds up quickly when compounded over many years.

Competition between Vanguard, Fidelity, and Schwab

In the index fund market, there are three major players: Vanguard, Fidelity, and Schwab. In addition, Blackrock iShares offers their low-cost index ETFs to Fidelity clients commission-free. When you have three billion-dollar companies competing for trillions of dollars in assets, competition ensues. Each of these companies aggressively advertises their index fund offerings, competing for your business. At one point, I speculated whether we would soon have an index fund with a 0.00% expense ratio.

Mutual fund companies are promoting index funds in ways they did not a decade ago. In years past, the typical mutual fund ad would typically show a fund’s past returns, which of course, would always have beaten their underlying index. Today, these companies buy large ads on the front page of the Wall Street Journal to highlight how their index funds have lower fees than their competitors. When Vanguard, Fidelity, and Schwab promote their index fund offerings, they are not just advertising the superiority of their fund offerings over their competitor’s offerings, but the superiority of index funds over actively-managed mutual funds.

One underappreciated reason for the popularity of index funds

While all of the above reasons are valid, I believe one underappreciated reason for the recent surge in popularity of index funds is simple: the stock market has done really well.

The bull market, which has been raging on since 2009, has given investors no reason to deviate from an index fund strategy. From 2009-2017, the stock market has had an annualized return of 15.4%, according to data from Portfolio Visualizer.

Even optimistic personal finance pundits like Dave Ramsey assume a 12% return on stock investments. If a passive index fund strategy can exceed that projection, as it has from 2009-2017, with few significant market corrections, there is no reason to deviate from an index fund investing strategy.

In addition, when the stock market goes straight up, actively managed mutual funds who try to time the market get burned. From 2009-2017, the best market timing strategy was no market timing strategy. Usually, in choppy markets, you can visualize some opportunities where you could have sold at the market top and rebought after a correction. The lucky fund managers who do so will advertise their luck to anyone who will listen.

The best-performing strategies always toot their horns, and money piles into those strategies. Since a buy-and-hold strategy with index funds has outperformed any attempt to time the market (whether it be with technical analysis or some global macroeconomic trading model), then it’s no surprise that the flow of money into index funds is accelerating.

What Will Happen When The Bull Market Ends?

Bear markets can be nasty. When the next bear market comes, inevitably there will be fund managers who predicted it and profited from it. They may or may not have also predicted a bear market in 2014, 2015, 2016, and 2017, but they will advertise how they were able to get out before the music stopped on the 2010s bull market.

It wouldn’t surprise me if the flow of money into index funds slows when the bull market of the 2010s ends. Investors, even index fund investors,  are all about “what have you done for me lately?” If index funds perform poorly over a period of years, alternative investment strategies will prop up. Of course, in the long-run, the expected return of an index fund portfolio is higher than an actively-managed fund portfolio because of the difference in fees. It’s important to stick with index funds even if they are not doing well in the short-term.

Looking at the historical market share of index funds over time, the only blip in the growth of the equity index fund market share was approximately in the 2007-2009 period, when equity index mutual fund share remained steady at approximately 18% before continuing its increase in market share (equity index fund market share was 34% in 2015). Now that index funds have become fully ingrained into the retail investor’s mind and index fund fees are nearly zero, a bear market could slow the growth of index funds or even cause active managers to briefly regain some of the market share it has lost.

Conclusion

There are many reasons why index funds have become so popular. In addition to the usual reasons of simplicity, low costs, and increased advertising/competition, the strong bull market and superior performance of an index fund portfolio has contributed to its popularity. My prediction is that index fund growth may slow when we hit a bear market, but investors should still invest in index funds, because it will have a higher expected return than an actively-managed alternative.

What do you think? Will the popularity of index funds slow when this bull market ends? Under what scenario do you think actively-managed mutual funds could begin attracting investor money again?

[Charts courtesy of StockCharts.com]