One of the best, though little practiced, ways to outrun a mild loss of purchasing power is through stock index funds.
Taylor Larimore and his wife Pat believe in low-cost index funds, although it took an experience with a stockbroker to become a convert. Taylor is an 80-year-old Miamian who was a Small Business Administration executive. The Larimores walked away from their broker in 1986 after “realizing how much we were paying in fees, commissions and poor advice.’’
Holding stocks within a passive index fund is usually an efficient way of licking inflation because management and tax expenses are low relative to actively managed funds.
Switching into nine Vanguard Index Funds, Larimore said he was glad to stop paying 8.5 percent commissions and 2 percent management fees on products offered by his broker.
Now Larimore says his total portfolio averages less than 0.25 percent a year in expenses and said that last year he achieved a 16.9 percent return. He also prefers index funds because they offer diversification, no manager changes, low turnover and “greater simplicity with peace of mind.’’
“Our indexing strategy has easily beaten inflation,’’ he says. “It’s the only strategy that guarantees we will never seriously underperform our benchmark index. It’s also a strategy that is guaranteed to outperform the average managed fund using the same market of securities.’’
The staid index fund has generally been an unheralded inflation beater when the economy is growing and inflation is held to low, single digits.
From 1926 through 2003, inflation has averaged about 3 percent, according to Ibbotson Associates, a Chicago-based research firm. During that period, a basket of large-company stocks — best represented by the Standard & Poor’s 500 Index — averaged 12.4 percent.
In 69 (overlapping) 10-year holding periods since 1926, large stocks failed to outperform inflation only seven times, mostly in the 1970s and early 1980s, times of constricted economic growth, the Ibbotson data show.
Ultra-safe U.S. Treasury Bills, in contrast, which track short-term interest rates, barely outpaced inflation since 1926, with those bonds averaging 3.8 percent over that period.
Index fund returns really add up if you have decades to invest. Let’s say you have $100,000 in your 401(k), your employer matches half of your $13,000 annual contribution, you receive 5 percent annual salary increases and your funds average returns of 7 percent every year.
If you could add 1 percent in return through saving on expenses using index funds, you would boost your retirement fund significantly.
That means you would walk away with $226,000 more in 20 years, according to the Bloomberg.com 401(k) calculator. You can make that gain without any timing skill, manager selection or special expertise.
Which Fund is Best?
Don’t be misled by a label, though. Not all index funds are low cost. As a rule, most index mutual funds that carry a sales charge will be a bad deal compared with a direct-sold fund and will needlessly devour returns.
A study last year by the Consumer Federation of America and Fund Democracy, two consumer groups, showed that 57 S&P 500 funds that track the popular large-company index carried an average expense ratio of 0.82 percent or 4.5 times the lowest fund they surveyed, the direct-sold Vanguard 500 fund.
An Exchange Traded Fund (ETF) is worth considering for large lump sums that you plan to buy and hold for three years or more. ETFs are highly tax-efficient indexed portfolios that are listed on a stock exchange. You can buy them through deep-discount brokers.
Prime candidates are the Ishares S&P 500 Index fund, charging 0.09 percent a year in fund expenses or the Vanguard Total Stock Market Index VIPERs with a 0.15 percent expense ratio, Bloomberg data show.
Choosing an ETF over an index mutual fund depends on how much and how long you plan to invest. For a $100,000 investment, you always prefer the ETF.
“Obviously, if you are making regular investments over time (and incurring brokerage commissions on each purchase), you may well be better off with the index mutual fund,’’ Coyne says.
For stocks to produce positive real returns (nominal returns minus the inflation rate), though, it helps if the economy and corporate profits are outpacing wage and price gains. Inflation gains the upper hand during periods of a stagnant or low-growth economy accompanied by relatively high price and wage increases.
For example, large-company stocks showed negative real returns in several 10-year periods into the early 1980s. The worst period for real large stock returns, according to Ibbotson, occurred between 1965 and 1974, when stocks returned only 1.2 percent and inflation averaged 5.2 percent.
Ask for Index Funds
Because the stocks-beat-inflation guideline doesn’t always work, create a diversified portfolio that includes inflation- sensitive investments such as Treasury Inflation Protected Securities, commodity and Real Estate Investment Trust (REIT) funds. These vehicles are well represented in the PIMCO Commodity Real Return Strategy and Vanguard REIT Index funds.
If your retirement plan doesn’t offer low-cost index funds (under 0.30 percent a year in total expenses), ask your employer to add them. The larger the plan, the more lower fees will enhance returns.
Institutional-class index funds, which are ideal for retirement funds with assets above $10 million, are generally available for 0.10 percent annually or less.
Like warehouse discount stores, the greater the volume (or assets invested in this case), the more you can save in index funds. And you’ll also give inflation a run for the money.