Indeed,
money flows into passive vehicles — including traditional index mutual
funds and the newer ETFs — have surged in recent years, as revealed in a report from
the Investment Company Institute. In 2013, for example, index mutual funds
attracted $114 billion in new cash (up from
$59 billion of inflows in 2012) and held $1.1 trillion in assets at
the end of the year. Demand for U.S. domestic equity index funds tripled
that year, and the share of indexed assets compared to all equity mutual
funds was 18.4% at year-end, reflecting steady growth from 9.5% in 2000, and
at an increasing rate beginning around 2007.
The ETF
structure has proven to be an exceptional draw for the indexing movement
because it permits investors to purchase shares at any time, unlike
traditional mutual funds, which transact on a daily basis at "net asset
value." Asset growth for ETFs was double that of index mutual funds between
2007 and 2013. Both types of funds attracted $795 billion in cumulative new
assets over that period. By contrast, active equity mutual funds saw money
outflows of $575 billion. Clearly, indexing has gained favor in recent
years; even investor Warren Buffett has included the methodology in his
estate planning and argues for its use by the average person as an
alternative to picking stocks or active funds.
Our take on
this debate reflects the "non-passive" investment approach that
we advocate — take action when and where necessary and appropriate. Necessary and
appropriate action is almost always
contrary to the market; indexing embraces the market. Most of the time
we are inactive, avoiding risk and patiently waiting for good investment
opportunities to appear. We also firmly believe that when it comes to
investing, things are never quite as simple as they sometimes appear, nor as
complicated as generally portrayed. We believe that smart investors should
maintain a high degree of skepticism about trends in the investment
business. We find that our own personal "Ockham's Razor" is very useful in
these situations: in finance it is
never a good idea to do what everyone else is doing.
It follows
that the popularity of indexing should instill caution at this time. The
last two decades have seen indexing twice gain favor — during the late 1990s
and now. Both episodes followed long periods of rising stock prices leading
to relatively high valuations (extremely high in the 1990s period). Market
history following the end of the prior outbreak of exuberant faith in the
market's future should be reason enough to proceed carefully.
This
argument from what we might call "market wisdom" finds backing in
fundamental considerations that should lead those contemplating buying into
the current indexing wave to examine the passive approach with a critical
eye. First, there is no such thing as
passive investing. The indexes on which "passive" funds are
based are artificial groupings of securities whose components are rejiggered
from time to time by their sponsoring organizations (Dow Jones, for example)
— hence,
they are actively "managed" just like any other fund, although usually with
far less turnover (one significant advantage of index funds). Second, and
more importantly, committing capital, whether to a stock, bond, oil futures
contract, property, or index fund, is an active decision entailing certain
expectations and consequences. Whether the consequences are pleasant or not
depends on whether the expectations were based on sound reasoning.
Sound
expectations are rooted in economic realities. Whether an index fund or a
share of stock, the ultimate result of any investment decision depends
largely on the price paid. The
value of a security or fund is the stream of future cash flows to which it
is entitled, "discounted" to the present at some interest rate. Pay a high
price and that rate — the "return" on your investment — could be very small, or
even negative. There is no escaping this essential factor. Any potential
capital commitment must be analyzed and its price/value characteristics
weighed. Operations failing in such analysis can quickly descend into
speculation. Those buying index funds in 1999 based on the simplistic notion
that just "owning the market" would get them 10% per year (a common belief
at that time) soon found themselves regretting that they had purchased an
asset that was "priced to perfection" with little prospect of yielding an
acceptable result (Actually, it was much worse. Due to the way in which
indexes are typically constructed, fund owners thinking they were buying
into a broad universe of companies were, in reality, putting most of their
money into a small number of stocks selling at bubble prices.).
Active
managers' broad failure to "beat the market" provides the passive side with
a potent argument that has the most sticking power in this debate. It, too,
deserves careful scrutiny. The meaning of the phrase "beating the market"
has evolved. Once applied to speculators who managed to get out of the
market with their capital intact, it now defines the investment industry's
aim to achieve results in excess of what the market (or a specified
"benchmark") provides — "alpha," to use the industry terminology. For the
untrained individual investor attempting to create their own portfolio of
securities or selecting from among the enormous variety of funds that are
now available, this is not a realistic goal. Research repeatedly
demonstrates that untutored individuals make very poor investment decisions.
One study in particular showed that over one 15-year period when stocks
returned about 12% annually, individuals trading mutual funds saw a 3%
return on investment using funds that, on average, had achieved returns of
about 10%. Why such a mediocre result? Individuals trade too much, buy high,
and sell low. From this perspective the 10% return from active management
represents considerable value-added on the part of fund managers, despite
their having trailed the indexes, when compared with what fund purchasers
themselves achieved.
If "beating
the market" is a false goal for individuals, it is a false god for fund
managers, as that 10% figure above is testimony. Over a period of decades
the money management and fund industries have become singularly focused on
this objective, in the process corrupting the investment process.
Short-termism and high rates of turnover create even more hurdles to good
results, especially on an after-tax basis. Activities once viewed as
speculative, such as trying to predict the next hot market sectors, have
become commonplace, even though they usually fail to produce any positive
"alpha." Paradoxically, trying to beat the market contributes to
"underperforming" the market. The market is best "beaten" when it is
ignored.
The
conditions needed to do well vis a vis market indexes are probably not
compatible with the industry's present structure and procedure set.
Competitive pressures are not conducive to patience. Long ago an investment
theorist said, "A good investment is not the same as a successful
speculation." Looking for a stock to "go up" faster than
your competitors' is a far different exercise that buying a business at a
reasonable price. The former is an enticement to jump ship at the slightest
disappointment, while the latter is more conducive to careful analysis and a
willingness to let things develop over time — the essence of true investment. Long-term
thinking is rare when corporate managements and institutional investors
collude in focusing on the short-term results required to feed the maws of
the bonus culture. Finally, the industry, having grown into behemoth and
bureaucratic organizations beset by their own imperatives, is simply unable
to respond in a nimble fashion to the ebb and flow of investment values.
If the aim
is to "outperform" everyone else, then investors face a daunting
task — do it
yourself and hope you get lucky, or place your trust in an industry whose
size and methods tend to promote mediocrity. There are no panaceas when it
comes to protecting capital and building wealth.
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