Thursday, July 6, 2017

Arguments Against Index Investing

I’m accustomed to reading arguments against index investing. The valid ones tend to point out that few index investors actually stick to their plans. The “other” arguments make less sense but get repeated frequently anyway. Jack Mintz managed to bring a great many of these less sensible arguments together in a recent short article. Here I examine Mintz’s claims.

“What happens if the day comes that the entire stock market becomes solely made up of passive investors?”

This won’t happen. We’re not close to it now. If we ever got close enough to 100% index investing, active stock picking would become profitable.

“The lure of sharply reduced investment fees has enticed millions of investors to shift their portfolios to passive investments.”

Calling low fees a “lure” implies that index investors can expect to get caught somehow. Mintz offers nothing to back this up.

“There are problems with all this passivity.”

I got to the end of the article without seeing anything to back up this vague claim of problems index investors can supposedly expect.

“Much of the argument in favour of passive investment is based on the presumed failure of active funds to provide superior pre-tax returns on a consistent basis compared to index funds.”

The failure of active funds to keep up with index funds is extremely well studied and documented. There is nothing “presumed” about it.

“But passive investment works when market prices convey all the information about a security.”

The implication here is that passive investment doesn’t work when market prices don’t convey all the information about a security. This isn’t true. The fact that the average index investor gets higher returns than the average active investor is based on simple arithmetic, not some variant of the Efficient Market Hypothesis. Only a small minority of active investors can outperform the index. The more efficient the market is, the tinier the minority of active investors who can outperform the index over the long term.

“In the presence of informational inefficiency, there is value to research and hiring advisers.”

The vast majority of trading is done by investment professionals. They can’t all beat the index. After factoring in costs, only a small minority can beat the index over the long run. Average investors have no idea which advisors will help them outperform. Trying to guess this correctly is as hard as being a superior stock-picker.

“Passive investors freeload on active investors in the presence of informational inefficiencies. Through their research, active investors will reallocate capital from poorer-performing to better-performing assets, thereby increasing the overall value of an index, making passive investors better off too.”

This is true, but it’s an argument in favour of index investing, not against it. The work of active investors sets good prices that index investors enjoy. Perhaps we’re supposed to be embarrassed to be considered freeloaders. I think active money managers can be considered freeloaders for the huge fees they charge for a service that consistently produces poor outcomes for investors.

“It’s obvious that relying only on an index is absurd.”

So far we’re being lured, we have problems, we’re freeloaders, and now we’re behaving absurdly. Flinging around such characterizations is easier than making a logical argument.

“Nortel made up 36 per cent of the TSX in 2000 and went bust a few years later. Meanwhile, funds based on an index will often end up holding many unprofitable firms.”

On the other hand, index investors rode Nortel on the way up, and they own many profitable firms. The implication here is that active managers avoided Nortel’s implosion (as a group, they didn’t), and they can avoid companies that will be unprofitable in the future (as a group, they can’t).

“When the U.K. ended embedded commissions, the result was that lower-wealth investors would not or could not pay for advice, leaving them less well-prepared for retirement.”

Lower-wealth investors in Canada are already very poorly served. Most of the time, salespeople sell them expensive mutual funds without providing meaningful advice. Quality financial advisors are almost exclusively available to investors with substantial portfolios.

“Instead of favouring passive investing over active investing, policy should instead remove barriers that make financial planning costly. Ottawa charges GST on financial-management fees.”

It’s not clear to me that removing the GST from financial-management fees would lower investors’ costs. Costs are unreasonably high now. What would stop fund companies from raising fees to fill the GST gap? If you think of the GST as an extra cost for investors, you probably want to remove it. If you think of the GST as taking a slice of fees away from fund companies and advisors, then you probably want to keep it (unless you work for a fund company or advisor).

“Fans of ETFs and the companies that market the funds insist that active investing can never beat passive investing, since no human can consistently outperform the market.”

Few people claim that no human can consistently outperform the market. After all, most of us have heard of Warren Buffett. What index investors claim is that the average index investor gets higher returns than the average active investor after factoring in fees.

“The overwhelming number of studies that test the difference between active and passive funds are deficient in some respects.”

To back up this claim, Mintz cites nitpicks about benchmarks and observes that some studies found that active management beat passive in certain time-frames or under other circumstances. The truth is that the overwhelming majority of studies clearly back up the simple arithmetic argument that active managers as a group cannot beat indexes.

It’s hard to know the real motivation of those who make arguments like this. One plausible guess is that while the arguments are easy to refute, they give advisors something convincing to say to their clients in a one-on-one setting with nobody there to offer counterarguments.

One point to be clear about here is that active investing is not the enemy. For one thing, active investors help to set good prices. Investors’ real enemy is high costs. In the U.S., Vanguard offers active mutual funds with low costs. These funds serve investors well.

The best criticism of index investing is that so many investors fail to stick to their plan. Some bail out when stock prices fall. Others tinker so much with their allocations that they’re effectively market timers. Some are poorly diversified.

The passive versus active debate isn’t going away any time soon. There are too many people who make their livings from expensive mutual funds to expect them to just give up.

8 comments:

  1. As someone who is an active investor I would still say that passive investing is a perfectly reasonable approach and many of the objections are very biased.

    I don't think that not sticking to a plan is really an active versus passive issue either. It may be more so a DIY issue, but you can be DIY with active or passive investments.

    Finally I would caution that there is a certain group of passive investors that are almost extreme in their support for passive investing and opposition to active investing that I think is excessive. The biggest issue is are you getting the support and advice you need and keeping costs relatively low.

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    1. @Devin: I've seen investors whose advisors were the ones who advocated selling one set of funds and buying another set. So, sticking to a plan isn't purely a DIY vs. advisor issue either.

      Can you point me toward a group of passive index investors with such extreme views? I tend to encounter many people who say nice things about index investing but don't quite index their own investments.

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  2. We have ~30% in index funds. And then another ~40% in supposedly active funds which are closet index funds. Altogether, way more than half the stock market = index investment. At what point active management will start beating the index? I don't know, it has not been tested.

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    1. @BHCh: It's impossible to tell the exact point when active management will get an edge, but from the analyses I've read, the ways that active management could exploit index funds' forced trades seem thin enough that the transition won't come until more than 90% of money is in index funds.

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  3. In regards to the debate about passive vs. active investing I totally agree that passive investing is the way to go. However, I don't think that purchasing an index fund is the only way to do this.

    Just because I own individual stocks does not mean that I am an active investor. An average of 5 trades per year (including initial purchases) over 12 years doesn't sound very active.

    Why not just look inside the fund to see what it is holding, then buy those equities in the same weights that the fund holds?

    You might argue that the cost of doing this is prohibitive. Well then just buy the top 10, 20 or 30 stocks. This portfolio will track fund's performance very closely.

    By the way, there is nothing magical about an index. It is simply a portfolio of individual stocks assembled using pre-determined specifications.

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    1. @John: The labels "active" and "passive" are unfortunate. When investors own just a few stocks, it makes them active in this context, even if they rarely trade. They may be less active than those who trade frequently, but they are still somewhat active.

      Owning just 10 to 30 stocks from an index will track the index fairly closely for most short periods, but there is significant risk of not tracking well over the long run. If you happen not to pick a few stocks that become big winners over time, it's possible to trail the index significantly.

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    2. Point taken.

      I should have gone into more detail. I own 28 stocks split between two portfolios (my wife's and mine). They are diversified across all sectors except mining with three of them being US multinationals (for global exposure).

      I know what you mean about missing out on a few winners. My wife's portfolio has outperformed mine over the last 10 years due to a few superstars and one dog, while my portfolio has mostly strong performers with one dog.

      Also, just for fun I calculated my costs over 12 years. Get this 0.98%. And that is a one time cost. Not year after year after year. That has to count as an advantage of individual stocks over a fund.

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    3. @John: When it comes to costs, I add in the cost of lack of diversification. If you're able to choose above-average stocks, then this doesn't apply. But for me, I assume that my choices are essentially random. This means that there is a compounding cost to being less diversified. At 28 stocks, this cost is higher than the 0.16%/year my index ETF portfolio pays in MERs, commissions, spreads, trading expenses within ETFs, and foreign withholding taxes. So, I prefer maximum diversification and low fees to owning stocks directly.

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