If you’ve been an investor for any length of time at all, then you’ve almost certainly been advised to start (and maybe even finish) with index funds like the Vanguard S&P 500 ETF. This fund is of course simply meant to mirror the performance of the S&P 500. And it is good advice. The fact is, in their efforts to “beat” the market, too many investors will actually end up underperforming it. The smart-money mindset is giving yourself the best possible chance at the best possible performance, which means first and foremost owning index funds.
Still, the idea of not trying to at least outperform the broad market is a tough pill for some to swallow. Is there not a happy medium solution that offers the best of both strategies?
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There is. The Vanguard U.S. Multifactor ETF (NYSEMKT: VFMF) is a rules-based fund that only holds stocks meeting a well-defined set of criteria meant to ensure above-average quality. Although it’s not based on a traditional index, it should in theory still act like one since its managers don’t make any discretionary buys or sells.
Nevertheless, this approach has still somehow lagged the market, surprisingly disqualifying this ETF as the prospective millionaire-maker it’s supposed to be.
And there’s an important lesson buried in the reason why.
The statistics regarding individual investors’ average annual returns are a bit fuzzy. But it’s not difficult to believe many of them underperform the S&P 500. Most mutual fund managers with time and the right tools to beat the market don’t actually do so, underscoring just how difficult it is for ordinary investors like yourself to achieve the feat.
Standard & Poor’s regularly updates its ongoing monitoring of this reality. Its most recent report on the matter indicates that over the course of the past five years a little over 77% of large-cap mutual funds available to U.S. investors — most of which would be considered actively managed — trailed the performance of the S&P 500. For the past 10 years, the underperformance figure grows to nearly 85% of these funds.
Perhaps even worse, the leaders of the five-year stretch aren’t the same leaders of the 10-year stretch.
And it’s not like this is a new phenomenon. Most fund managers, money managers, and even hedge funds have lagged the S&P 500’s performance for the past several decades. These concerning odds are the chief reason you really should consider at least starting your investing journey by laying a foundation with index funds.
So where does Vanguard’s U.S. Multifactor ETF fit into the strategic picture?
If you’re not familiar with such funds, don’t be too intimidated by the word “factor.” These are just rules or criteria that must be met to add a particular stock to a fund’s holdings. In the case of this particular exchange-traded fund, Vanguard’s key factors are valuation, momentum, profitability, and leverage (debt levels). By applying these criteria, Vanguard aims to own only the market’s higher-quality names. More to the point, this approach means Vanguard’s fund managers sidestep the risk of making an emotionally-charged buy or sell decision about a certain stock… which is how most individual investors stumble into trouble.
Except it hasn’t worked.
Oh, the Vanguard U.S. Multifactor ETF does avoid the inherent performance-crimping perils of making judgment calls on individual equities. This fund hasn’t achieved its intended market-beating results, though. In fact, it has regularly underperformed the S&P 500 and Vanguard’s S&P 500 ETF.
VOO Total Return Level data by YCharts
What gives? This lagging performance proves something most veteran investors innately understand. That is, although hand-picking stocks always imposes the risk of injecting faulty assumptions into the process, picking stocks isn’t purely a matter of valuation and fiscal performance, either. Some degree of judgment is merited.
Problem? It’s incredibly difficult to distinguish between using too much personal judgment and not enough, just as it’s incredibly difficult to know which fundamental criteria to regard and which to ignore.
This proverbial stumbling block is why simple indexing should be at least part of your strategy. With this approach you don’t face the risk of guessing wrong and missing out — you simply plug into the stock market’s well-proven long-term growth potential.
You could still become a millionaire by owning the Vanguard U.S. Multifactor ETF rather than a more straightforward index fund like the Vanguard S&P 500 ETF. Anything’s possible.
The odds of you becoming a millionaire are considerably higher, however, with the S&P 500 index fund than it is with the multifactor ETF that doesn’t actually offer the superior gains it’s supposed to produce. You’d certainly reach the seven-figure market sooner with the more basic S&P 500 ETF, which generally produces the same average annual net return of right around 10% that the underlying index does.
To this end, investing just $500 per month in an S&P 500 index fund averaging an annual net gain of 10% — and reinvesting any dividends it paid out along the way — in a tax-deferring IRA would leave you with a little more than $1 million after 30 years. It would take you several more years to do the same with the multifactor ETF.
Bottom line? Don’t confuse “sophisticated” with “superior.” Sometimes the simplest, most basic approach really is the best way of doing things.
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James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
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