What is an index mutual fund? It is simply any mutual fund that simply mimics a stock index (such as the Standard & Poor's 500, the Mid Cap 400, or an international index). Many people equate these funds with the Vanguard Index 500 Fund, which John Bogle popularized, but many others offer the Standard & Poor's 500 as an index fund . . . and there are many other indexes you can buy mutual funds for. If you want to know more about this subject, this book has excellent explanations in chapter 14.Let me begin by saying that this book has many flaws. An outstanding book on how to be a very successful index fund investor has yet to be written. But this book goes much further in that direction than any other book I have read on the subject. If you also read Stocks for the Long Run and Common Sense on Mutual Funds, I think these will clear up the missing elements in this book. Some embarrassing typos still remain, but they are annoying rather than fatal.
The book has two parts. The first part compares indexed mutual funds to nonindexed (or actively managed) mutual funds. The second part looks at 5 steps to creating greater wealth using indexed mutual funds.
The arguments in part one basically document that indexed mutual fund returns after taxes and after expenses have been higher than almost all managed (nonindexed) mutual funds over long time period. The reasons mostly relate to higher expenses due to management fees, marketing costs, and commissions caused by more turnover of stocks for the managed funds, disadvantages of a large portfolio for buying and selling, and inefficient tax effects of high turnover in taxable accounts. The authors also look at the effects of perfect information, and how much return you get for how much risk. These arguments are well done and accurate. Two elements that were new in this book included looking at the arguments that Peter Lynch and other active managers have made against indexed mutual funds, and looking at risk versus reward.
The five step process in the second part of the book is:
(1) Get a personal financial plan (with goals stated in dollar terms)
(2) Get a personal investment plan (a strategy to meet your goals)
(3) Invest with a diversified portfolio of index funds, tailored to fit your needs
(4) Get maximum benefits from the tax laws to delay and reduce taxes
(5) Buy and hold your portfolio, after starting as soon as possible.
Each of these points is somewhat detailed with descriptions of various ways to go about it, alternative sources of advice and information, and ways to make contacts with the advice and information. More could have been done on the first category, but the latter two were well done. The reasons for these factors are better explained in most cases in Stocks for the Long Run than here.
I particularly liked the advice to create a worldwide portfolio of indexed funds. Most books on indexing miss that point. The argument is flawed here, however, in only looking backward at what would have worked best in the past. If the rest of the world continues to grow its economies faster than the United States, the best returns will probably be from being overweighted into international indexed funds to reflect the future balance of market values rather than the current one.
The main weakness of the second part is that it lacks much quantification. But if you read the Bogle and Siegel books that I suggested above, those will more than fill in the gaps for you.
You should also be aware that recent evidence suggests that Malkiel's insistence on totally efficient equity markets is coming more and more into question. Our own research at Mitchell and Company supports the growing skepticism. However, active managers have been slow to adapt to the new information about where the markets are inefficient. Eventually, new indexed products should develop to take advantage of these inefficiencies. The main weakness seems to be a preference for basing indices on the financial data that active managers prefer. That's simply our old friend the disbelief stall in action. If the measures that active managers use do not beat the averages, why should indices based on those same measures be the best way to construct an index?
Like all books on index-based investing, this one is long on the arithmetic and short on the psychology needed to be successful. Most people know how to make more money than they do in stock market investing, but do the wrong thing anyway. Until someone makes a more psychologically appealing case for indexed mutual funds, most people will continue to favor the lower-performing nonindexed funds.
