New Arguments Against Low-Cost, Passive Investing Are No Better Than The Old Ones

Since the GFC, index funds have taken a huge slice of investable assets globally. And in my opinion, rightly so. There will be many that disagree with me on this, but let the evidence and data speak for itself I say. For every winning stock picker, there is a loser – it’s just how it works. Unless active funds dramatically reduce their fees, index funds will always be at or near the top quartile of long-term performance.

The premise of active management is essentially that with enough skill, it’s easy to consistently outperform the market, or the benchmark. When this view was challenged decades ago, it sparked a longstanding debate with strong believers on both sides, and some in between.

If you want to see some of the data, you can click here. The SPIVA (S&P Index Versus Active) Scorecard is a robust, widely-referenced research piece conducted and published by S&P that compares actively managed funds against their appropriate benchmarks on a semiannual basis.

Investors have been voting with their feet and ploughing money into index funds over the last 10 years. Vanguard, the primary beneficiary of this evolution, took in as much as its eight competitors in 2017.

In fact, over the last 8 years, Vanguard’s total Assets Under Management (AUM) has grown exponentially from US$1 trillion to over US$5 trillion. Mind blowing.

The more investors passive funds attract, the more they’re criticized. And all the new arguments you hear against low-cost, passive investing are no better than the old ones.

There are three reasons why indexing has become so popular. First, it costs less — often much less. High fees are a drag on returns; compounded over decades, they lead to a 20 to 30 percent penalty on total returns. Next, the alternative is active-stock or mutual-fund selection or some form of market timing. Academic research overwhelming shows that the vast majority of investors lack the skills or discipline to do that. Attempts at out-performance invariably lead to under-performance. Last, even among those who have the requisite skills, the discipline and emotional control necessary to successfully manage money is intermittent at best, absent at worst.

Market Watch recently published an opinion column arguing index funds are terrible for our economy and highlighted 3 key areas indexing is creating a risk to our markets and economy. Barry Ritholtz responds to each of these in order:

Index funds contribute to market melt-ups and meltdowns.

Really? That statement is at odds with the experience of most Registered Investment Advisors (RIAs) and index-fund managers. Indeed, we have experienced several bubbles and crashes, melt-ups and meltdowns, during the past few decades. The evidence is clear that passive-index investors behave better than active-fund investors or market timers, tending to blunt rather than aggravate volatility.

During the financial crisis, passive investors sat tight and for the most part didn’t sell. Indeed, they were net buyers, according to former Vanguard Chief Executive Officer Bill McNabb. As my Bloomberg colleague Eric Balchunas pointed out, during the 2008 credit crunch, the money flows were into index funds and exchange-traded funds, in part because they displayed less volatility; more than $205 billion was put into these funds while active funds experienced $259 billion in withdrawals.

“Index funds reduce the quality of stock analysis.”

If this were offered as a joke, we could ignore it. But this is a serious — and a seriously flawed — allegation.

Let’s be blunt: Stock analysis has been famously terrible for most of forever. Analysts are too bullish when things are going well, and perhaps too bearish when they are not. They are highly conflicted. Since research itself doesn’t generate income, analysts are paid out the funds generated by other parts of a securities firm’s business, such as investment banking. Their goal is to encourage more active trading, which generates commissions but also higher tax bills and lower returns. For a reminder of how problematic Wall Street research is, recall the analyst scandals of the late 1990s and early 2000s.

I believe this author has it exactly backward: Expensive and ethically compromised analysts were shown to be of so little help to investors that they actively contributed to the rise of indexing.

“Index funds contribute to poor corporate governance.”

Again, I think this is exactly backward — it’s the long-term owners of public stock, that is, index funds — that management must deal with year after year.

Consider what Dave Nadig, managing director of ETF.com (part of CBOE Global Markets) wrote earlier this year:

State Street voted against the slates of directors proposed by companies over 400 times, because those companies failed to add women to their boards. And BlackRock recently published an open letter to markets, putting every company on notice that they would be taking a hard, hard look at everything from executive compensation to community development to environmental impact.

Active managers and activist investors can threaten to sell their stock, and sometimes they do. But then what? The indexers are long-term owners — and they vote their proxies. Management has to acknowledge their permanence.

The complaints about indexing have become tiresome: Indexing is Marxist, it’s a bubble waiting to burst, it’s dangerous to the economy or the efficiency of the market, and so on. The need to relitigate every lost battle is telling. The people who want to sell you newsletters, expensive mutual funds, or costly trading advice have suffered greatly from the move toward low-cost, passive investing. No wonder so many of them refuse to accept the obvious benefits of indexing to average investors.

END

Next time you’re looking at your investment statement, take a moment to think about how much you’re leaving on the table – 10, 20, 30%? The fact that investors choose to, year after year, make voluntary donations via the sacrifice of returns from their portfolio to those that purport to be able to ‘beat the market’ astounds me.

There’s a great book by Fred Schwed Jr. titled, Where Are The Customers Yachts?, which exposes the folly and hypocrisy of Wall Street. The title refers to a story about a visitor to New York who admired the yachts of the bankers and brokers. Naively, he asked where all the customers’ yachts were? Of course, none of the customers could afford yachts, even though they dutifully followed the advice of their bankers and brokers. Full of wise contrarian advice and offering a true look at the world of investing, in which brokers get rich while their customers go broke, this book continues to open the eyes of investors to the reality of Wall Street.

Source:

  • Bloomberg – https://www.bloomberg.com/opinion/articles/2018-12-12/index-investing-critic-takes-aim-fires-misses
  • Market Watch – https://www.marketwatch.com/story/your-love-of-index-funds-is-terrible-for-our-economy-2018-12-10
  • Morningstar
  • SPIVA