A financial adviser's worst nightmare has been taking place recently as more clients have been reading the news and learning that just a simple S&P 500 index fund has outperformed just about every imaginable combination of investment types over the past three years.
Typical of most index funds, the annual cost amounts to free money management -- as little as 5/100ths of 1 percent or about $50 per year on each $100,000 invested. For this pittance, the fund companies keep track of the money, send quarterly statements, answer the phone, send automatic deposits to personal checking accounts and even maintain an online account that allows investors to mess with their money with a few key strokes here and there. So, the question clients have for their advisers is, "What do I need you for?"
The appropriate response for the adviser is that he or she has a longer memory. If we were having this conversation toward the end of 2010, the S&P 500 index had earned an average 10-year return of zero, which prompted the period to be dubbed "The Lost Decade." By comparison, a diversified mix of different equity asset classes that included small company funds, international funds, emerging markets, real estate, etc, would have earned about 6.5 percent per year during the same 10-year period -- which included the greatest market collapse in 70 years.
Fundamentally, an index fund is a broad cross section of company stocks in proportion to the size of each company's value of their outstanding shares available in the stock market. At first glance, a casual observer would assume that money in an S&P 500 index fund was spread out over 500 companies and that this represented plenty of diversification. Unfortunately, the value is disproportionately weighted toward a handful of the largest companies that make up half of the entire value of this popular index. The 15 largest companies comprise 22 percent of the total value. Apple alone represents almost 4 percent. Half of the entire value is concentrated in about 50 large companies. The remaining 450 companies make up the other half. So much for diversification.
When the world goes to hell in a hand basket, it tends to focus on the part of the stock market that has been the hottest performer. In 2000, it was tech. In 2008 it was financial services. The 500 index lives by the sword and dies by the sword. Technology boosted the index up over 20 percent per year for four years in a row in the late '90s until the asset class represented more than 30 percent of the entire index value. By 2007, financial services companies making a fortune packaging mortgages and creating derivatives out of thin air represented almost 40 percent of the 500 index's value.
When we think about it, the broad market index fund had adopted its own version of the now-disparaged "corporations are people" mantra. On paper, index funds are attempting to reflect a dispassionate, mechanical investment in stocks that makes no attempt to second-guess as to which companies might be tomorrow's winners. What that fails to recognize is that the index itself reflects the effects of the investing public's "irrational exuberance" as well as its panic. It's the market operating as a "voting machine," as Warren Buffet describes it, that determines the proportionate shares that make up the 500 index at any given time. In effect, the index acts like a person.
So, the 500 index lost 45 percent in the early 2000s while small cap value and REIT funds gained 50 percent during the same period. By late 2009, small cap and emerging markets funds came out of the blocks quickly while 500 index funds languished. Looking at the 10-year average annual returns for almost all types of equity funds, the returns tend to center around 9 percent to 10 percent with the 500 index only now struggling to catch up at 8 percent per year. The question for most investors is to ask if an adviser helped them remain diversified, stay the course and not bail out at a low point of either the market or their psyche. If so, that adviser is probably worth paying some reasonable fee.