There seems to be a consensus among people who know what they’re talking about that the fees you pay on actively managed funds are a waste of money. But I saw some friends arguing about investing on Facebook, with one guy claiming that index funds are not actually the best way to go for diversified investing that does not waste any money on fees. Does anyone know if there is anything too this? More specifically, are Vanguard’s funds really as cheap as advertised, or is there some catch to them?
The idea is that you can’t, on average and long term, beat the market. So paying extra money for a fund that claims to be able to do that is an unnecessary gamble. Accumulating the expertise to evaluate a fund’s ability to perform better than the market would give you the ability to just invest at that level anyway, so you might as well save your time and money and stick it in the cheapest market funds you can manage.
Yes, some strategies beat the market, sometimes (they also sometimes fail catastrophically). But you can do pretty damn well comparably in the long term by having a very low-cost, low-effort strategy that frees up a lot of time and effort for other pursuits.
This seems like a really weird question. If your friend is advocating something else, how about you tell us what it is? If your friend is knocking Vanguard, but not specifying what’s better, why should I care? Your last sentence suggests that Vanguard is lying about it’s fees. That would be a reasonable thing to say in isolation, but it’s not true.
Most likely the alternative is to pay his friend to actively manage your money using his secret knowledge.
This does not automatically mean the friend is wrong. But I also wouldn’t expect any kind of proof or guarantee. We are moving from the evidence area to “just trust me, I’m smart” area.
Asset allocation matters too. Vanguard target retirement funds follow the conventional wisdom (more stocks when you’re young, more bonds when you’re older) and are pretty cheap. Plowing all new investments into a single target-date fund is good advice for most people*.
I implemented a scheme to lower my expenses from 0.17% to 0.09%, but it was not worth the time, hassle, and tax complications.
*People who should do something more complicated include retirees, who should strongly consider buying an annuity, and people who are saving to donate to charity.
The issue with an index fund that based on something like the SAP 500 is that the SAP 500 changes over time.
If a company loses their SAP 500 all the index funds that are based on the SAP 500 dump their stocks on the market.
On average that’s not going to be a good trade. The same goes for the trade of buying the companies that just made it into the SAP 500. On average you are going to lose some money to hedge funds or investment banks who take the other side on those trades.
In general you can expect that if you invest money into the stockmarket big powerful banks have some way to screw you. But they won’t take all your money and index funds are still a good choice if you don’t want to invest too much time thinking about investing.
This sounds like a sufficiently obvious failure mode that I’d be extremely surprised to learn that modern index funds operate this way, unless there’s some worse downside that they would encounter if their stock allocation procedure was changed to not have that discontinuity.
They do because their promise is to match the index, not produce better returns.
Moreover, S&P500 is cap-weighted so even besides membership changes it is rebalanced (the weights of different stocks in the portfolio change) on a regular basis. That also leads to rather predictable trades by the indexers.
This sounds like a sufficiently obvious failure mode that I’d be extremely surprised to learn that modern index funds operate this way, unless there’s some worse downside that they would encounter if their stock allocation procedure was changed to not have that discontinuity.
Being an index fund is fundamentally about changing your portfolio when the index changes. There no real way around it if you want to be an index fund.
If you could consistently make money by shorting stocks that are about to fall off an index, the advantage would arbitraged to oblivion.
The question is whether you know that the stocks are about to fall off the index before other market participants. If your high frequency trading algorithm is the first to know that a stock is about to fall off an index, than you make money with it.
Using the effect to make money isn’t easy because it requires having information before other market participants. That doesn’t change anything about whether the index funds on average lose money on trades to update their portfolio to index changes.
are Vanguard’s funds really as cheap as advertised, or is there some catch to them?
There is no catch, you don’t pay anything other than their advertised fees. Andrew Tobias has been using them as an example of a great way to invest in the market for years. (His writings on investing are great, ignore anything he says about politics on his blog.)
IIUC, since most transactions in the stock market are zero-sum (at least in terms of money), the fact that index funds make money despite using very simple and predictable strategies implies that on average, everybody else manages to do worse.
Nope, that’s not how it works. Just because the transaction is zero-sum doesn’t mean the value is zero-sum.
Consider (abstract) agriculture. You buy seeds, that’s a “zero-sum” transaction, plant them, wait for them to grow, pick the harvest and sell it in another “zero-sum” transaction. Both your transactions with the market are zero-sum and yet… :-)
Specifically, stock market is not zero-sum game.Therefore the fact that (some) index funds (sometimes) make money does not imply that the everybody else does worse.
Consider (abstract) agriculture. You buy seeds, that’s a “zero-sum” transaction, plant them, wait for them to grow, pick the harvest and sell it in another “zero-sum” transaction. Both your transactions with the market are zero-sum and yet… :-)
Yes, but you can’t plant stock options in the ground, and in fact you can’t really do anything with them other than selling them or keeping them and cash the dividends (assuming that you don’t buy enough shares of a company to gain control of it).
Since different people can assign different utility to cash and can discount future utility differently, it is possible that a transaction is positive sum: e.g. consider an old person with a short remaining life expectancy selling all their stocks to a young person. But at the level of large investment funds and banks, these effects should mostly cancel out, therefore the stock market is approximately zero-sum (up to events that alter the amount of available stocks, such as defaults, IPOs and recapitalizations)
Stock options are very different from stock shares. I assume you’re talking about shares.
Stock shares represent part ownership of a company. The fact that you’re likely to be a minority owner and have no control over the company does not change the fact that you are still legally entitled to a share of the company’s value. If the company’s value rises, the value of your share rises as well.
it is possible that a transaction is positive sum
If you’re talking about personal subjective utility, every voluntary transaction is positive-sum. But that’s irrelevant for the purpose of this discussion since here we are talking dollars and not utilons.
therefore the stock market is approximately zero-sum
You still don’t understand. Public companies (generally) create value. This value accrues to the owners of the companies who are the holders of stock shares. In the aggregate, stock holders own all the public companies. If the public companies produced value, say, this year, the value of the companies themselves increased. This means that the worth of the stock in the stock market has increased—even if no transactions have taken place. That is why stock market is not a zero-sum game.
Stock options are very different from stock shares. I assume you’re talking about shares.
Yes, sorry about the imprecision.
If the public companies produced value, say, this year, the value of the companies themselves increased. This means that the worth of the stock in the stock market has increased—even if no transactions have taken place. That is why stock market is not a zero-sum game.
I didn’t claim that owning stock shares produces no value. I claimed that most trades involving stocks (those which neither increase nor decrease the amount of stocks) are zero-sum w.r.t. monetary value.
Consider Alice and Bob who have the same utility function w.r.t. money and the same discounting strategy. Alice sells a share to Bob at price X. Alice is betting that the total discounted utility from the dividends gained by owning the share indefinitely is less than the immediate utility of owning X, while Bob is betting that it is greater than that. Clearly they can’t be both right. The gain of one is the loss of the other.
the fees you pay on actively managed funds are a waste of money.
Generally it depends and there are certainly exceptions, but this position is a good prior to be modified by evidence. Absent evidence it stands :-)
Investing is complicated. There is no simple, bulletproof, one-size-fits-all recipe. To talk about “the best way” you need to start by specifying your goals and constraints (including things like risk tolerance) -- that’s surprisingly hard.
Topic: Investing
There seems to be a consensus among people who know what they’re talking about that the fees you pay on actively managed funds are a waste of money. But I saw some friends arguing about investing on Facebook, with one guy claiming that index funds are not actually the best way to go for diversified investing that does not waste any money on fees. Does anyone know if there is anything too this? More specifically, are Vanguard’s funds really as cheap as advertised, or is there some catch to them?
The idea is that you can’t, on average and long term, beat the market. So paying extra money for a fund that claims to be able to do that is an unnecessary gamble. Accumulating the expertise to evaluate a fund’s ability to perform better than the market would give you the ability to just invest at that level anyway, so you might as well save your time and money and stick it in the cheapest market funds you can manage.
Yes, some strategies beat the market, sometimes (they also sometimes fail catastrophically). But you can do pretty damn well comparably in the long term by having a very low-cost, low-effort strategy that frees up a lot of time and effort for other pursuits.
You can look up expense ratios on Google, Morningstar, etc. Vanguard does pretty well. They’re pretty well represented here.
This seems like a really weird question. If your friend is advocating something else, how about you tell us what it is? If your friend is knocking Vanguard, but not specifying what’s better, why should I care? Your last sentence suggests that Vanguard is lying about it’s fees. That would be a reasonable thing to say in isolation, but it’s not true.
Most likely the alternative is to pay his friend to actively manage your money using his secret knowledge.
This does not automatically mean the friend is wrong. But I also wouldn’t expect any kind of proof or guarantee. We are moving from the evidence area to “just trust me, I’m smart” area.
Asset allocation matters too. Vanguard target retirement funds follow the conventional wisdom (more stocks when you’re young, more bonds when you’re older) and are pretty cheap. Plowing all new investments into a single target-date fund is good advice for most people*.
I implemented a scheme to lower my expenses from 0.17% to 0.09%, but it was not worth the time, hassle, and tax complications.
*People who should do something more complicated include retirees, who should strongly consider buying an annuity, and people who are saving to donate to charity.
The issue with an index fund that based on something like the SAP 500 is that the SAP 500 changes over time.
If a company loses their SAP 500 all the index funds that are based on the SAP 500 dump their stocks on the market. On average that’s not going to be a good trade. The same goes for the trade of buying the companies that just made it into the SAP 500. On average you are going to lose some money to hedge funds or investment banks who take the other side on those trades.
In general you can expect that if you invest money into the stockmarket big powerful banks have some way to screw you. But they won’t take all your money and index funds are still a good choice if you don’t want to invest too much time thinking about investing.
This sounds like a sufficiently obvious failure mode that I’d be extremely surprised to learn that modern index funds operate this way, unless there’s some worse downside that they would encounter if their stock allocation procedure was changed to not have that discontinuity.
They do because their promise is to match the index, not produce better returns.
Moreover, S&P500 is cap-weighted so even besides membership changes it is rebalanced (the weights of different stocks in the portfolio change) on a regular basis. That also leads to rather predictable trades by the indexers.
Being an index fund is fundamentally about changing your portfolio when the index changes. There no real way around it if you want to be an index fund.
If you could consistently make money by shorting stocks that are about to fall off an index, the advantage would arbitraged to oblivion.
The question is whether you know that the stocks are about to fall off the index before other market participants. If your high frequency trading algorithm is the first to know that a stock is about to fall off an index, than you make money with it.
Using the effect to make money isn’t easy because it requires having information before other market participants. That doesn’t change anything about whether the index funds on average lose money on trades to update their portfolio to index changes.
There is no catch, you don’t pay anything other than their advertised fees. Andrew Tobias has been using them as an example of a great way to invest in the market for years. (His writings on investing are great, ignore anything he says about politics on his blog.)
IIUC, since most transactions in the stock market are zero-sum (at least in terms of money), the fact that index funds make money despite using very simple and predictable strategies implies that on average, everybody else manages to do worse.
Nope, that’s not how it works. Just because the transaction is zero-sum doesn’t mean the value is zero-sum.
Consider (abstract) agriculture. You buy seeds, that’s a “zero-sum” transaction, plant them, wait for them to grow, pick the harvest and sell it in another “zero-sum” transaction. Both your transactions with the market are zero-sum and yet… :-)
Specifically, stock market is not zero-sum game.Therefore the fact that (some) index funds (sometimes) make money does not imply that the everybody else does worse.
Yes, but you can’t plant stock options in the ground, and in fact you can’t really do anything with them other than selling them or keeping them and cash the dividends (assuming that you don’t buy enough shares of a company to gain control of it).
Since different people can assign different utility to cash and can discount future utility differently, it is possible that a transaction is positive sum: e.g. consider an old person with a short remaining life expectancy selling all their stocks to a young person. But at the level of large investment funds and banks, these effects should mostly cancel out, therefore the stock market is approximately zero-sum (up to events that alter the amount of available stocks, such as defaults, IPOs and recapitalizations)
Stock options are very different from stock shares. I assume you’re talking about shares.
Stock shares represent part ownership of a company. The fact that you’re likely to be a minority owner and have no control over the company does not change the fact that you are still legally entitled to a share of the company’s value. If the company’s value rises, the value of your share rises as well.
If you’re talking about personal subjective utility, every voluntary transaction is positive-sum. But that’s irrelevant for the purpose of this discussion since here we are talking dollars and not utilons.
You still don’t understand. Public companies (generally) create value. This value accrues to the owners of the companies who are the holders of stock shares. In the aggregate, stock holders own all the public companies. If the public companies produced value, say, this year, the value of the companies themselves increased. This means that the worth of the stock in the stock market has increased—even if no transactions have taken place. That is why stock market is not a zero-sum game.
Yes, sorry about the imprecision.
I didn’t claim that owning stock shares produces no value. I claimed that most trades involving stocks (those which neither increase nor decrease the amount of stocks) are zero-sum w.r.t. monetary value.
Consider Alice and Bob who have the same utility function w.r.t. money and the same discounting strategy. Alice sells a share to Bob at price X. Alice is betting that the total discounted utility from the dividends gained by owning the share indefinitely is less than the immediate utility of owning X, while Bob is betting that it is greater than that. Clearly they can’t be both right. The gain of one is the loss of the other.
Sounds like a fully general counter-argument against investing.
No, you can invest in index funds and make money or invest in securities not traded on the stock market.
Generally it depends and there are certainly exceptions, but this position is a good prior to be modified by evidence. Absent evidence it stands :-)
Investing is complicated. There is no simple, bulletproof, one-size-fits-all recipe. To talk about “the best way” you need to start by specifying your goals and constraints (including things like risk tolerance) -- that’s surprisingly hard.