Filed under: Investing Basics, Index Funds, Investing
The shell game that is active management is based on the fact that observers tend to confuse luck with skill. When a fund manager has a few good years, the financial media anoints him as the next market guru. This charade continues until the manager loses his "magic touch" and gives back all or most of the profits generated by his lucky streak. Nobel laureate Eugene F. Fama and finance professor Kenneth R. French wrote a seminal article differentiating luck versus skill in investing.
As information about the failure of active management has become more widely disseminated, investors are voting with their money. Over the 12-month period ended June 30, the total market share of net sales for all index-based and other passive funds was 68 percent, compared with only 32 percent for actively managed funds.
Active fund managers are not taking this reversal of fortune lying down. The article by Investopedia, titled "5 Reasons to Avoid Index Funds," is an excellent example of an attempt to divert investors away from intelligent, evidence-based investing. Let's look at the article's five reasons for avoiding index funds.
1. Lack of Downside Protection
Investopedia warns its readers that investing in an index fund "leaves you completely vulnerable to the downside." This is a common argument used by proponents of active management. Here's the problem. Active managers don't protect you in a down market either.
According to an analysis by Vanguard, the majority of active managers outperformed the market in only three of six U.S. bear markets, and in only two of five European bear markets. The study concluded that active managers have been "inconsistent" in bear markets, thereby debunking the popular myth that bear markets give them an opportunity to demonstrate their expertise.
Protecting yourself from a bear market is simple. Reduce your allocation to stocks so you can wait out the decline in stock prices until the market recovers. But don't wait for a bear market to reassess the risk you are taking in your portfolio. This should be an ongoing process.
2. Lack of Reactive Ability
Investopedia asserts that sometimes "obvious mispricing can occur in the market" and that active management can take advantage of this "misguided behavior."
Whenever you hear claims about the wisdom of any investing approach, ask this question: Where is your data? Investopedia doesn't refer its readers to any data or studies demonstrating the ability of active managers to identify -- much less take advantage of -- stock mispricing. There's a reason for that: The dismal performance of active managers over both the short and long term makes it extremely unlikely that people with that expertise exist.
3. No Control Over Holdings
Investopedia believes another disadvantage of index funds is that you have no control over the holdings in your portfolio. It's true that you can't make decisions about what goes into an index, but why would you want to? The whole purpose of owning a globally diversified portfolio of low-fee index funds is to capture the returns of those global indexes. You can best achieve this goal by mirroring them, which those funds do.
On the other hand, you should be cautious about holding individual stocks. The chances that you'll be able to identify a mispriced stock are no better -- and probably significantly worse -- than those of active fund managers, who have far greater resources. And even with those resources, their track record on stock-picking is nothing to emulate. Still, if there are individual stocks you really want to add to your portfolio, there's nothing stopping you from doing so without disturbing your index fund holdings.
4. Limited Exposure to Different Strategies
Investopedia claims that buying an "index of the market" may not give you access to many "good ideas and strategies." It counsels investors to do their own homework to find "the best value stocks, the best growth stocks and the best stocks for other strategies."
The fallacy that amateur (or even professional) investors can "do their homework" and consistently "beat the markets" is a cruel joke. We don't even need to speculate about the daunting odds you face if you elect to follow this advice. Many studies have found the average mutual fund significantly underperforms its benchmark before taxes -- and especially after taxes. The odds of a portfolio of 10 equally weighted actively managed funds, rebalanced annually, beating their benchmark have been calculated at a puny 0.055 percent over a 10-year period. In gamblers' parlance, that's around 1,800 to 1 odds.
Do you still want to "do your homework" and try to "beat the market"?
5. Dampened Personal Satisfaction
Investopedia stretches reality with the contention that index investors will still find themselves "constantly checking on how the market is performing and being worried sick about the economic landscape." The reality is quite the opposite.
Well-advised, index-based investors pay little attention to short-term market fluctuations. They focus on their asset allocation (the division of their portfolio between stocks and bonds). They aren't concerned about what happens in the market today, tomorrow or even over the next few years. They don't need to be.
Investors who "do their homework" and engage in stock picking, market timing and fund-manager selection, however, are buffeted by market volatility. They bounce in and out of the market, often in response to predictions made by self-proclaimed "gurus." They don't rely on peer-reviewed data. They often don't understand risk, and rarely have a well-thought-out investment policy statement, much less the discipline to stick to it.
So There You Have It
There's a lot of profit for Wall Street's so-called "experts" in dissuading you from following a simple, evidence-based index fund strategy. But it's profit for them, not for you. Don't be fooled.
Daniel Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."
