The Many Flavors of Index Investing

The misconceptions about indexing, especially from those that have their wagon hitched to the active complex (mutual fund companies, institutional research, insurance companies, mainstream media), run deep.  Quite literally, if you own anything other than a market cap weighted global portfolio you are an active investor.


Choosing which ETFs/passive mutual funds to own in the context of a multi-asset portfolio is very much an active decision.  Quite often, it’s the most important decision an investor will make (What is Asset Allocation?).  We run through several iterations of passive portfolio examples to illustrate that not all “indexing” strategies are created equal.  Indexing has evolved from owning the S&P 500 to fully managed asset allocation models that aim to provide solid risk-adjusted returns.     


For consistency, we will use Vanguard mutual funds and ETFs across each example.  We run data from January 2011-December 2016 and assume income is reinvested.*


Bogle Version – The Original Mutual Fund Indexing Strategy


Vanguard S&P 500 Index Fund (ticker VFINX) 100%


Compounded Annualized Return:12.30%


Risk:11.31%


Max Drawdown:-16.31%**


Cost:.14%


Comments:The original form of indexing.  Owning ~500 of the largest U.S. stocks by market capitalization (largest companies have the higher weightings).  Some have argued the self-rebalancing nature of the S&P, lowest market-cap stocks are replaced by larger market-cap stocks (link), is an active strategy.  


Two-Asset Portfolio– Early “Innovation” ETFs


Vanguard S&P 500 ETF (VOO) 60%

Vanguard Total Bond Market ETF (BND) 40%


Compounded Annualized Return: 9.10%


Risk:7.19%


Max Drawdown:-8.12%


Cost:.04%


Comments:The traditional 60/40 portfolio.  This has remained a viable benchmark for balanced portfolios. 


Multi-Asset Indexing – The New Framework


Vanguard S&P 500 ETF (VOO) 30%

Vanguard Total Bond Market ETF (BND) 40%

Vanguard FTSE Developed Markets ETF (VEA) 12%

Vanguard Small Cap Value ETF (VBR) 10%

Vanguard FTSE Emerging Markets ETF 8%


Compounded Annualized Return: 7.00%


Risk:7.61%


Max Drawdown: -10.91%


Cost:.06%


Comments:A more dynamic twist on the traditional 60/40 model.  Foreign equities and emerging markets dragged during the back-tested period, however, this portfolio has performed nicely in 2017 as international stocks have outpaced U.S. markets.


Utilizing low-cost index vehicles still requires active asset allocation decisions (i.e. how much an investor owns in U.S. Large Cap, International Equities, High Yield Bonds, etc. will “explain” most of the portfolio returns).  In our opinion, today’s environment is the best time to be an investor, we can express our active views of the world at a fraction of the cost. 


*All data compiled from Portfolio Visualizer (link).  For our reader’s sanity, we stick to three simplistic examples.  To learn more strategic and tactical asset allocation, please reach out for a more detailed discussion.


**Max drawdown – steepest peak to trough decline in the given time period.

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