Volatility Slams the Return on Index Funds

The Return on Index Funds

Rises with the Aloofness of the Investor

and Falls with the Volatility of the Market



high level of volatility in the market prods investors into fiddling with their portfolios, thereby slashing the return on investment for index funds. By trading in and out of the stock market at precisely the wrong times, the fidgety players end up shooting themselves in the foot.

Over the long haul, the sprightly segments of the market are apt to outpace the other branches. The dynamic niches include bantam firms, technology ventures, and emerging regions. On the downside, though, the spry markets tend to be more roily than the rest. 

Unfortunately, the investing public has a way of dashing in and out of the market at just the wrong moments. As a result, the punters give up a great deal of the gains on offer in the lusty domains. The higher the volatility, the greater in general is the lag of the investor behind the target index. 

On the upside, though, there is a straightforward way for the mass of investors to boost their earnings by a significant amount. The gamers could enjoy a plump increase in profits if they would stop meddling with their portfolios and simply ignore the goings-on in the marketplace. Moreover, the benefits of a laissez-faire policy grows with the turbulence of the market, along with the flightiness of the corresponding index fund.

Blowback from Excessive Meddling


In spite of all their efforts to outrun the market averages, the mass of investors manage to attain precisely the opposite result. Taken as a whole, the strenuous efforts of the hustlers all but come to nought. 

Remarkably, the final outcome is actually worse than zilch. Despite the great toll in sweat and tears as well as time and coin, the slew of schemes meant to beat the market end up producing worse results. 

Whether the eager beavers happen to be full-time professionals or part-time amateurs, the lure of quick riches is in general too tempting to ignore. But the hustling gives rise to impulsive moves which turn out to be counterproductive.

Slow Lane Beats the Fast Track


Glitzy schemes for trumping the market averages may look alluring at first glance but in fact tend to be harmful for investors. Instead of jumping on the fast track, the vast majority of players could grow their nest eggs a lot faster by taking up a slow and steady approach.

For this purpose, a trenchant course is to keep the faith in index funds whose mission is to track the benchmarks of the market. An investor who can keep up with the yardsticks will perform far better than the bulk of their peers. The punters in the latter category include full-time pros as well as part-time tyros.

In the chaos of the financial markets, the simplest and quickest way for most investors to boost their performance is to stay clear of flaky schemes for beating the market averages. Instead, the uncommon feat of keeping up with the benchmarks would place the wily players in a class of their own.

To some folks, the task of matching the market yardsticks may seem like the choice of a defeatist. To be fair, though, the move should not be viewed in a pessimistic light. Rather, the ploy is in fact a sensible way for most players to bolster their return on investment (ROI) as well as beat the bulk of the competition. 

In the hustle and bustle of the financial bazaar, the sworn enemies of the investor are the goblins of greed and fear. Needless to say, these ghouls show up most often, and inflict the most damage, in the throes of a tempestuous market. 

As it happens, the most promising niches tend to be the most turbulent ones. For instance, the companies plying their trade in the technology sector or emerging markets face a choppy environment compared to their peers dealing with consumer staples or diversified businesses. Due to the heightened risk, the equities of the firms in the stormy niches tend to be more jittery than the others. 

Unfortunately, the roller coaster of the stock market throws the investors for a loop. The plight of the riders is spotlighted by the lousy payoff from index funds. 

The role of an index fund is to replicate the performance of a benchmark in the marketplace. In that case, the patrons of the pool should in principle be able to keep up with the target market. Sadly, though, the practice differs grossly from the theory.

Volatility Spoils Temperance and Profits 


In the world of index funds, a leading light is found in John Bogle, founder of the Vanguard Group of investment vehicles. The patriarch examined the returns for 79 index funds in a number of categories over a period of five years ending in 2009. Each of the investment pools was structured as an exchange traded fund (ETF) whose shares could be bought and sold just like any other equity in the stock market. 

According to the survey, the investors lagged the turnout of the index funds across the board. The best showing – meaning the least underperformance – occurred for the customers of the vehicles that adopted a value-oriented approach to investing in large companies. 

Serene Cruise


For the sedate funds focused on big firms, the return on investment for the average pool was minus 1.8% per year. By contrast, the corresponding figure for the customers of the very same vehicles was negative 2.2%. In other words, the investors trailed behind the average fund in this group by a small gap of 0.4% per annum.

An investment fund that takes a value-oriented approach to picking stocks is apt to produce a sedate ride compared to the bulk of its peers. For this reason, we would expect a lot of the customers to stay put rather than jump ship during the upswings and downstrokes in the marketplace.

In that case, the clients in general would have no reason to trail behind the vessels themselves. This type of reasoning is in fact borne out by the data. 

Of the nine funds included in this category, the investors were able to keep up with the vehicle in nearly half the cases. From the opposite stance, the patrons lagged their rides in five out of the nine cases.

Modest Tossing


The equities of midsize firms straddle the middle range between the extremes of volatility. For this reason, we would expect the investing public to fare worse with mid-cap stocks than with their larger siblings. 

The foregoing study included five funds which focused on a blend of mid-cap stocks. For each of these vehicles, the customers trailed behind the ETF itself. 

Within this category, the average gain eked out by the funds was positive 0.4%. On the other hand, the mean return for the investors was negative 3.0%. In other words, the patrons lagged the funds by 3.4% per year on average.

Rough Ride


At the far end of the scale, the worst performance cropped up for the funds in the financial sector. Within this cluster, the average return for the pools was negative 10.7% per year. 

In contrast, the mean performance of the customers was minus 28.6% per annum. Based on the latter two figures, the underperformance of the investors was negative 17.9% a year on average.

The second worst category lay in emerging markets. For this breed of index funds, the average pool was able to snag a profit of 15.6% a year. 

On the other hand, the investing public managed to turn in only 3.8%. In other words, the gamesters trailed behind the index funds by 11.8% a year on average (Bogle, 2009). 

Not surprisingly, the underperformance of the patrons was universal for the roughest rides. Of the five funds focused on the financial sector, the customers trailed behind the vehicle in every case. The story was similar for the three vessels focused on emerging markets.

Normal versus Oddball


At this stage, we ought to note a couple of routine as well as exceptional aspects of the findings laid out above. The generic trait involved the fact that the size of the lag by the investors was closely linked to the volatility of the market. 

The rougher the ride, the greater was the underperformance. The reason, of course, is that the gamesters have a habit of dashing in and out of the market at precisely the wrong times. The plungers pile into the ring in the heat of a bubble when they should be running away; and they flee in panic in the depths of a crash when they ought to jump in with both feet.

On the other hand, the unusual outcome of the foregoing study lay in the grody outcome for the financial sector. The dire result can be traced to the extreme turbulence in the market amid the widespread buckling of commercial banks, insurance firms, and the like during and after the financial crisis of 2008. 

As a rule, the most jumpy segments of the stock market are to be found in the dynamic niches such as emerging markets, technology ventures, and small companies. By contrast, the most stable branches relate to large firms, utility companies, health care, and the like.

In spite of the differences, though, one common thread runs throughout the marketplace. The higher the volatility, the greater is the underperformance of the investor.

Given this backdrop, most investors would enjoy a sizable increase in earnings if they could stop meddling with their portfolios and simply ignore the goings-on in the bazaar. Unfortunately, the general public has a way of dashing in and out of the market at exactly the wrong times. 

The greater the tumult in the forum, the bigger in general is the lag of the investor behind the target benchmark. Given this backdrop, the best thing that the vast majority of punters can do for themselves is to follow a two-step procedure.

The first act is to set up a program of automatic investments into one or more index funds dealing with the vibrant segments of the marketplace. The branches in the latter category span the gamut from health care and digital technology to midsize firms and emerging regions. 

The amount of allocation will of course depend on the individual circumstances of the investor. An example in this vein is the level of disposable income or the degree of risk tolerance.

The second – and far more difficult – task is to ignore the bourse completely over extended spells. In fact, the wisest course of action for a lot of folks is to stay away from the financial bazaar for years or even decades on end.

Less is More for the Investor of Index Funds


To round up, myriads of punters could improve their performance by a hefty amount if they would just stop fiddling with their assets. For the bulk of investors, the ease of snagging higher returns without any effort to speak of happens to be a gift of the financial bazaar. Sadly, most of the punters opt to cast aside the free lunch available to all comers.

In short, the mass of investors can profit from a simple way to uplift their performance. In dealing with volatility of the market, the trusty way for most players to boost their earnings is to step aside and stop meddling with their portfolios; in that way, the index funds can get on with their work of cranking out a decent return on investment.

Reference


Bogle, J. C.  “Index Funds in Mid-2009: A Status Report.”  Also titled as “Fireside Chat: A Discussion With John Bogle.”  2009/6/17.  http://www.indexuniverse.com/docs/BogleWebinar.pdf – tapped 2011/3/4.

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