Index Fund’s: It’s Not So Simple
“Naturally the disservice done students and gullible investment professionals who have swallowed EMH has been an extraordinary service to us . . . In any sort of a contest — financial, mental, or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.” — Warren Buffett
Whether you make use of a discount brokerage, a sleek new financial app or lean on the advice of a financial advisor, you have more freedom to explore the stock market than ever before.
But technology and competition don’t guarantee positive results.
Investing is in some ways a so-called “loser’s game” in which the first key to winning is to avoid big mistakes. Especially when the stock market is hot, individual investors all too often fool themselves into thinking they are smarter than they really are. They become infatuated with the latest trend, or with a “hot” investment tip and become convinced they can earn abnormal returns and, possibly, get rich.
This applies to professional investors as well — many of whom not only fail to beat the market, but who underperform the market, sometimes by a good deal.
The investments of actively managed mutual funds, for example, are overseen by professional portfolio managers who closely monitor their funds and have access to the best available research. In any given year, many of these funds will successfully beat the market, and it is on that basis that they sell themselves to investors. Yet over a given 10-year stretch, most actively managed stock funds will fail to outperform their relative benchmark (the standard or average achieved by similar funds). A recent Standard and Poor’s study found that zero out of 2,862 managed mutual funds consistently fell into the top quartile (or 25%) of performers from 2009–2016.
But you already know this…
If you’ve searched for any sort of investment advice within the past half-decade, you’ve heard about index funds — cheap mutual funds that use algorithms to mirror certain broad market indexes like a basket of the 500 largest U.S. companies, known as the S&P 500. Because there is no real overhead to run an index fund, they’re cheap. And because of that reason, many think Index funds are the perfect investment.
While I agree that Index funds are brilliantly valuable securities for individual investors, it’s not so simple so deem them perfect, or even the best option. (Though, John Bogle’s mission to promote index funds might one day go down as one of the greatest services to humanity in the 21st century).
I argue that different markets (bull and bear) call for very different strategies. Even if your objectives are modest and you are mostly seeking to capture the long-term upward trend of the market, it is one thing to ride a bull, and another thing entirely to ride a bear.
The “Random Walk” School of Investing
The indexing craze really started in the early 70s, when economist Burton Malkiel published A Random Walk Down Wall Street (which is still one of the most influential books on investing). Malkiel helped bring the theories of academic superstar Eugene Fama and company to a wider audience. He echoed the Efficient Market Hypothesis thesis that stock price fluctuations are random and unpredictable, and that in the long run it is folly to try to outperform the market. The old saying, ‘If you can’t beat ’em, join ‘em,’ was basically Malkiel’s advice: Instead of trying to beat the market, be content with riding it and taking advantage of its long-term upward trend.
The advice was met with some resistance from investment professionals because Malkiel was essentially questioning whether they were providing real value for their clients. But his book arrived at a critical time for the field of investing. First, the stock market was in the middle of a long slump, and skeptical investors were open to new ideas. Second, institutional investors (like mutual funds and pension funds) were responsible for a growing share of the stock market (from 34% in 1969 to 43% in 1978), and were looking for predictable performance with low risk. Finally, the new field of finance economics, with bases at schools like the University of Chicago and MIT, was finally being taken seriously on Wall Street.
Malkiel would spend 28 years at the Vanguard Group, a leader in developing and promoting so-called “index funds” that use formulas to mirror the market (or a segment of the market) rather than trying to beat it. This kind of “passive” investment strategy (in addition to arguably reducing risk) comes with a lower cost to the investor, as well as certain tax advantages. It is thus no coincidence that Malkiel is now affiliated with Wealthfront, the largest of the new “robo advisor” services that employ algorithms to provide investors with low-cost, largely passive investment strategies.
So… Index Funds?
To be perfectly clear, Index funds are passively managed mutual funds that — in contrast to actively managed funds that try to beat the market — use a set formula to mirror the market, or a particular segment or index of the market (sometimes called a benchmark). For example, the first index fund, still one of the most popular, is set up to mirror the S&P 500 (the 500 biggest companies in the U.S., as measured by total capitalization). They’re growing rapidly, In 2016, active funds experienced a net “outflow” for the first time since 2008 — in other words, more money was withdrawn than invested. Active funds lost $207 billion while index funds gained about twice as much. And in the last fifteen years, passive funds’ share of the equity mutual fund market has more than doubled: from less than 10% to over 20%.
An index fund is kind of one-stop shopping option on your investing menu. With a single lump-sum investment, you can own a piece of dozens (or even hundreds) of companies or other assets. If, for example, you want to ride the long-term growth of the top companies in the U.S., you can buy into an S&P 500 index fund. If you then want to balance that investment in domestic stocks with a sampling of international stocks, you might invest in an Emerging Markets index fund. Throw in a bond index fund and you would have a fairly well-rounded portfolio. In each of these instances, you don’t have to research individual stocks. You are counting on the index you are tracking, or on the manager of your fund, to make your investment decisions for you.
And this is where the debate about actively managed funds comes in. The argument for such funds is as follows… Say you’re an investor who is serious about building real long-term wealth. You’re not content to simply ride the market. With at least some of your investments, you’d like to outperform the market, and you are willing to pay higher fees for the opportunity to do so. On the other hand, you don’t have the time or inclination to research individual stocks, and you’re willing to pay someone a reasonable fee to do that homework for you, in return for a decent chance that they will be able to beat the market over time.
Sounds like a good deal, doesn’t it? And during the bull market of the 80s (1982–1987) and 90s (1987–2000), it was an attractive and increasingly popular option with investors. Mutual funds routinely reported returns in double figures, and high-profile fund managers like Fidelity’s Peter Lynch (who, over a 10-year period, beat the S&P 500 by an impressive 150%) achieved almost superstar status. Hundreds of new funds were created and the competition between them was intense — yet more people were winning than losing.
But then the dot-com bubble burst, followed by a decade with big gains at some times and big losses at others. It now appears that the 90s were the exception rather than the rule, creating unrealistic expectations about the stock market in general, and mutual funds in particular. Moreover, a growing number of studies question whether the performance of actively managed funds justifies their higher fees.
John Bogle, the founder of Vanguard and creator of the first popular index fund, is a big proponent of the EMH view, and has been arguing for passive investing since the 1970s. In 1995, even while actively managed funds were flying high, he wrote an article entitled “The Triumph of Indexing.” And as of 2010, his boast seemed to have come true. Increasingly, investors have been taking money out of active funds and putting them into passive indexes. And in 2010, his Vanguard Group passed Fidelity (known for actively managed funds like Magellan) as the world’s largest mutual fund company.
Moreover, a number of studies appear to support the case against active management. Foremost among these is Standard & Poor’s comparison of index and active funds — the SPIVA Scorecard (S&P Indices Vs. Active). Issued twice a year, the most recent scorecard for 2015 finds that 66% of large-cap, 57% of mid-cap, and 72% of small-cap active funds, failed to meet their benchmark (the index they would track if they were passive funds). The numbers are even worse when extended over a 10-year periods. S&P also issues a Persistence Scorecard to assess whether funds are able to maintain above-average short-term performance over time. Again, the numbers aren’t pretty. Of the 678 domestic equity funds that were in the top quartile (25%) in September 2013, only 4.28% were similarly ranked two years later. SPIVA also found a very high “mortality rate” for actively managed funds. In the past five years, a fourth of all active domestic equity funds either merged or were liquidated.
Why are “expert” fund managers, with all the research tools in the world at their disposal, so consistently bad at beating the market?
• Size — Simply put: the bigger a ship, the harder it is to change course. Markets are cyclical and investors can become irrational. The best investors learn to quickly adjust, and to protect their portfolio from market extremes. Large funds are for the most part unable to do so. Also, because of their size, investing in small, dynamic companies often isn’t worth the trouble — effectively shrinking a fund’s universe of investment-worthy stocks.
• Psychology — Fund managers are generally compensated based on how they perform relative to their benchmark, so they often have an incentive to play it safe and simply try to stay even with (or even slightly behind) the pack, as opposed to trying to beat the market. This herd mentality is especially evident during a heated bull market. If a given index is surging (such as what happened with tech and internet stocks in the late 90s), the majority of managers end up riding the wave and investing in the same popular stocks (in the business we call this “chasing performance”).
• Timing –Sometimes the smartest investing move is the non-move: knowing when to hold off, rather than (in baseball terms) swinging at a bad pitch. Professional fund managers usually don’t have this luxury. As new money comes in, they can’t just sit on it, even if they suspect the market is overvalued and overpriced. It’s a particular problem during a bull market when, because of recent performance, a fund attracts a lot of new investors — a phenomenon called forced buying. Timing can adversely affect investors another way. A fund might, for instance, report a 20% annual return in a good year. But, unless you were on board from the beginning, you’re not going to see all or even most of that. Individual investors also chase performance, jumping on the bandwagon of a hot fund, not at the bottom, but as it nears its peak. One study estimates that this “timing penalty” costs individual investors 5% in returns each year.
• Concentration (not enough of it) –The limits of diversification are nowhere more evident than in the world of mutual funds, especially the biggest, most popular ones. Despite studies showing that the benefits of diversification drop off greatly once you hit 20 to 30 stocks, many funds insist on maintaining dozens, even hundreds of holdings. At a certain point, this “excessive diversification” (as some call it) is self-defeating: you end up mirroring the market and losing any chance of beating it. And, if all you do is match the market, your returns (once you factor in the higher fees charged by active funds) are bound to disappoint.
Making Sense of the Active vs. Passive Debate
Armed with the findings of the SPIVA Scorecard and similar reports from financial research firms like Morningstar and Lipper, some experts and commentators are ready to declare the debate over, and to name passive indexes the winner. “Active fund management is outmoded,” writes respected Wall Street Journal columnist Jason Zweig, “and a lot of stock pickers are going to have to find something else to do for a living.” As we’ve seen, investors certainly continue to vote that way with their money.
But is the issue really so cut and dry?
A lot of it comes down to how you define a truly “active” fund. As I pointed out above, a number of funds are so broadly diversified that they are active in name only. Researcher Antti Petajisto calls such funds “closet indexers” and has been working on ways of identifying them and distinguishing them from truly active funds. He and his colleague Martijn Cremers have developed a measurement of a fund’s “Active Share” — that part of a fund’s portfolio where managers are making strong individual choices, rather than just following the crowd or an index. They have found that funds with an Active Share rating of 90% or higher actually do stand a good chance of beating the market. Morningstar and Lipper provide active share ratings to subscribers, and Fidelity now tracks the active share of all its funds.
Analyst and fund manager Thomas Howard also questions the conventional wisdom about the underperformance of actively managed funds. His research concludes that the returns of such funds are held back by three factors he combines into a Portfolio Drag Index. Closet indexing is the most significant of these, followed by overdiversification. Related to both is a third he calls “asset bloat.” Fund managers are not only compensated based on performance relative to a benchmark, but also on how big the fund is: total Assets Under Management (AUM), as it’s known in the industry. As the fund grows and (over)diversifies, the quality of its investments becomes diluted. Howard finds that most of a fund’s chance for superior performance can be found in its first 20 investments: these are its best ideas, its “high-conviction” picks. But, with the average fund now comprising over a hundred holdings, it has four or five times more low-conviction stocks than high-conviction ones.
Don Phillips has been with Morningstar for thirty years, a number of them as its head of research. In an article called “Indexing’s Noble Lie,” he chastised Bogle and other proponents of indexing for overstating their case and mischaracterizing the performance of active funds. He acknowledges that passive investing is “a smart, savvy, and intelligent way to invest, provided it is broad-based, low-cost indexing.” He also says it is irresponsible to ignore or dismiss the top tier of managers capable of outperforming the market. He believes in screening such managers based on two simple criteria: 1) Whether they have lower than average expenses; and 2) whether they have “skin in the game,” or more than $500,000 invested in their own funds. This is a group “that will perform as well, if not better, than the average index fund.”
Most investors are not served by an either/or approach. A number of high-profile articles have appeared in the last year or two offering a contrarian view to the prevailing wisdom that index funds are necessarily superior: And, while Vanguard is known for championing passive indexing, about half of its funds are actively managed. In some years those active funds outperform its passive ones; and Vanguard has conducted extensive research on the keys to a successful active fund.
Here are a few key things to keep in mind when choosing a mutual fund:
• In general, index funds perform best in long, steady bull markets — during which they are an excellent instrument for riding a rising tide.
• When markets are highly volatile or experience sudden downturns, a good active manager has the ability to “play defense” against the market’s irrationality while an index fund may well be swept up in that irrationality.
• In certain areas requiring prudent judgment — especially foreign stocks and municipal bonds — actively managed funds consistently outperform passive ones.
• If you choose to explore active funds, you don’t need a lot of them: the more such funds you have, the more your overall portfolio will look like a passive index.
• Active funds tend to do better when interest rates are rising, and also when there is a large performance gap between the best and the worst funds (known in the industry as “dispersion”).
• An advantage of index funds is that they require very little research, something that can be appealing to the novice investor. They also come with less emotional strain because there is no expectation of beating the market.
The point of examining mutual funds and the ongoing debate about the merits of active vs. passive management is not because I think they are necessarily the best investment vehicle available to you but because they are a popular and easy way to get your feet wet in the market. And if that’s what it takes to start exposing yourself to the greatest wealth accumulating tool known to man, the stock market, by all means invest in Index funds.
But just understand that they’re not the perfect investment. Remember what I said before: Different markets call for different strategies. In its simplest form, indexing means riding the market and it’s an entirely different thing to ride a bull than ride a bear!
This article originally appeared on Grow