difficult, which is why Buffett’s record is so unusual. Here
are a few reasons why a large-company index fund, like one modeled
on the S&P 500, is so formidable an opponent:
• The Standard & Poor’s 500 is well diversified by industry.
• It is well diversified by stocks. (The Vanguard 500 Index has
around 506 stocks, the extra ones being for both A and B shares,
like those of Berkshire Hathaway, which—for some strange reason—
are not in the S&P 500.)
• An index fund based on the S&P 500 will normally have low expenses.
There are few changes in its composition, so trading
costs are minimal; there aren’t high salaries for a manager or for
various analysts.
• Most index funds are capitalization weighted; the bigger companies
(measured by price times shares outstanding) have more effect
on the index than the smaller ones. So, in a sense, an index
fund practices momentum investing; stocks that do well begin to
occupy a greater and greater role in the index, and stocks that do
poorly begin to occupy a lesser and lesser role. This explains
why value investing and index-fund investing may alternate periods
of glory. If they buy stocks in the S&P 500 Index, value investors
tend to buy the companies that have been shrinking.
• The indexes are not so passively managed as some people
think. The better companies are chosen for the index in the first
place; when a stock must be replaced, it is replaced by a stellar
company; when a company already in the index has been doing
abysmally, like Westinghouse or Woolworth, it may also be replaced
by a thriving company. (Granted, the committee that decides
which securities should remain in an index and which
should be booted out is not infallible; in 1939, IBM was kicked
out of the Dow Jones Industrial Average.)
• An index fund won’t have a manager to blame if the fund does
poorly; shareholders may be more likely to continue holding on
because, clearly, there’s no one to heap abuse on for any mistake.
Shareholders may be more likely to desert an actively
managed fund—and when they do flee, the manager may be
forced to sell stocks at what may be the wrong time. Or the
manager may be discharged, and his or her successor may
drastically revamp the portfolio—just when the first manager’s
strategy is finally kicking in. I once told John Bogle that one
benefit of an index fund is that the guy who’s not managing it
today will be the same guy who’s not managing it 20 years from
now. He smiled.
Read More : Why It’s So Hard to Beat an Index Fund?
