I am not a “pure” index guy. We do use indexes, but they are built using academic data from Center Research of Security Prices and they are then built by institutional fund companies and they don’t use “popular” indexes (why this is is a topic for another post) so the costs are even lower than the products are even more efficient than the ones he discusses below.
The article is good because it captures the essence of the debate. — John Pollock
5 Lies About Index Funds
By RICK FERRI
Financial incentives encourage advisors to talk trash about indexing.
The truth about index investing must be told over and over again because lies are constantly being told around it. Many of those telling lies are financial advisors whose income depends on their client’s use of high-cost active management strategies. They view simple, low-cost passive strategies through index funds as bad for their business.
I started out about 22 years ago as an investment professional monitoring and evaluating active managers. As a result of this experience, by the mid-1990s, I became an avid believer in what John Bogle, Charley Ellis, Burton Malkeil and many others had been saying for a long time. The fees in active funds are too high, the talent too scarce, and competition too intense for active managers to outperform indexing in the long-term. Ellis cleverly described the entire process as a loser’s game.
My book, The Power of Passive Investing, provides summaries of exhaustive academic studies covering the active versus passive debate going back many decades. Every study in the book ends with the same conclusion; while a handful of active managers beat their benchmarks due to skill, it wasn’t by much, and most didn’t sustain that benchmark-beating performance for long. In addition, it’s not possible to determine luck from skill or to pick skilled managers in advance. To make matters worse for investors, the success rate for a portfolio of funds drops precipitously as more active funds are added to the portfolio.
With the evidence overwhelmingly in favor of passive investing for the long-term, why won’t more advisors admit these facts and shift their focus to advising clients on the benefits of index investing rather than making believe they’re market gurus or trying to pick those who are? One reason – there’s a lot more money to be made by keeping the lie alive. The fees and commissions earned through active investing are considerably higher than what should be earned by telling the truth about passive investing and charging a fair fee for this advice. Even those advisors who have switched can’t bring it upon themselves to lower their own fee. See my recent article on High-Fee Passive Advisor Hypocrisy.
Brokers in particularly are deeply set against index fund investing because they believe it’s very bad for their revenue stream. Their efforts to sell costly actively-managed mutual funds have generated a lot of trash talk about low-cost index funds. The following is a list of 5 common lies spun by advisors who are dead-set against indexing.
- Active US stock funds beat the market over the past decade. Less than 50 percent of surviving US stock funds beat the S&P 500 since 2000, and this number would be much lower if closed and merged funds were included. But that’s not the problem with this argument. The primarily large cap S&P 500 is not a good benchmark for many actively managed US equity funds because they have a small cap or mid cap focus. Using appropriate size benchmarks brings the percentage of winning funds down considerably.
- Index funds will always achieve below average returns. Index funds will achieve returns that are much closer to the market averages than the active funds your advisor is pushing, and that’s what matters. On average, mutual funds underperform by the fees they charge. Index funds have much lower fees than active funds. This makes low-cost index fund investing an above average portfolio strategy.
- Indexing doesn’t work in inefficient markets such as small cap or international. You can count on every active fund advocate to use poorly constructed or inappropriate indexes to make the argument that active returns are better than they are. For example, the Russell 2000 is a common benchmark for US small cap stocks, but it has known annual reconstruction flaws that reduce its annual return by up to 2 percent. The MSCI EAFE is a common international equity benchmark, but it doesn’t include popular emerging markets stocks or Canadian stocks. Proper benchmarking makes active management far less attractive.
- Active managers perform better in bear markets. The evidence surrounding this often heard statement is inconclusive. The data does show that active funds tend to hold more cash in a bear market due to greater fund redemptions, and this can create the impression of lower risk, but there’s no evidence supporting the idea that active funds have lower volatility or that fund managers have market timing skill.
- Warren Buffett has beaten the market and this proves indexing doesn’t work. Wrong. This only proves that Warren Buffett, chairman of Berkshire Hathaway (Ticker: BRK), has the Midas touch. It doesn’t prove that the advisor you’re using has Buffett-like talent. Your portfolio may beat the market due to luck, but let’s not be naive and call advisor luck as skill. Even Buffett repeatedly recommends that individual investors buy index funds that charge minimal fees. As an aside, I find it ironic that most advisors who use the Buffett argument typically don’t own BRK in their client’s portfolios. [Buffet is not an active manager, he buys undervalued companies and then restructures them back to profitability and then holds on to them-JP]
Indexing works because active investing can’t work. The fees are too high, the opportunities too few, and the talent too scarce. Ignore the lies told by those people who earn a fat living selling the dream of market beating returns. You’ll earn more money over your lifetime by creating and maintaining a low-cost, low-tax, low-turnover portfolio of index funds.