Investing: Lazy and Complacent Wins the Race

It’s Monday morning and I dialed up the weekly podcast of a financial advisor that I’ve been listening to for 10-plus years   . . . for so long in fact that I initially listened on AM radio and later via the web (before podcasts were ubiquitous and easily accessible). I turned the volume up when this host declared that he was going “off-script,” and proceeded to spend 30 minutes comparing the returns of the S&P 500 index to those of Berkshire Hathaway over the last 50 years. Since 1965 the S&P has delivered annualized returns of approximately 9.9%, compared to 20.9% for Team Buffet at Berkshire. The host then contrasted the terms “investor” and “saver,” apparently arguing that plain-vanilla indexers aren’t real investors but merely savers that accept “inferior returns.” He continued to label S&P 500 indexing as “lazy and complacent,” and implied that saving money is well and good, but that to get to financial independence you really needed to hit portfolio-return home runs. He even muttered something about these inferior index returns being un-American.

All this from a professional financial advisor with a wide podcast distribution that has advocated index investing for at least a decade by my count. He is a fee-only, fiduciary-standard, registered investment advisor, so he has set up his advisory business the right way (i.e., he’s not getting commissions for selling his clients inferior securities that they don’t need or for churning their brokerage accounts), and he consistently ranks as one of the top financial advisors in his region on the basis of assets under management. So I had to stop and ask the question: what gives? Why the about-face, and with no explanation whatsoever? Apart from the personal confusion that I experienced as a result of this apparent inconsistency, I also worry about the new listener that may have been left with two critical misperceptions: (1) that investment returns are more important than saving (nope); and (2) you have to swing for the fences in your investing style in order to get to financial independence (bullsh*t).

The Hard Data Regarding Active-Management Performance

You don’t have to look very hard to find the damning empirical evidence regarding the under-performance of active management (as a group) over longer periods of time (that is, periods of time that are relevant for investors rather than traders or speculators). In fact, as I fired up the browser to go look for a version of this year’s data, I fortuitously found an email in my inbox from Vanguard that pointed me to a white paper titled The Case for Low-Cost Index Fund Investing. The white paper contained a version of what I was looking for: data showing that over any meaningful period of time (5-plus years), the vast majority of actively managed funds under-perform their benchmark index. (And while Berkshire Hathaway is a publicly traded stock, it is in substance a functional equivalent of an actively managed mutual fund.) Here’s a look at the relevant data from the Vanguard white paper (US equity funds in green; foreign equity funds in blue; US fixed income in purple):

% of active funds under-performing the “style benchmark” over 5-, 10-, and 15-year periods.

Note that the lighter shades on the bars represent the “dead” funds that closed and are likely often excluded from other statistical analyses because they no longer exist at the time of the data-gathering process. Here’s what the 1- and 3-year evaluations look like:

The 1- and 3-year evaluation periods

What we see here is that at a 1-year measurement interval you get a number of funds that perform at or above the level of the benchmark index—roughly 65% in the mid-cap growth category, just to pick one data point that is most favorable to the active-management perspective. But as you move the time-horizon out longer, the winners segment shrinks dramatically. The favorable mid-cap growth category shifts to approximately 80% under-performers in the 10-year review, and roughly 90% in the 15-year review. In any given year a fund can have a hot hand and post stellar market-beating results, but can that same fund do it year after year? The data indicates that a very small sliver of the actively managed universe can do it. Berkshire is an outlier example. The folks at Vanguard summarized the data nicely:

“This is not to say that there are not periods when active management outperforms, or that no active managers do so regularly. Only that, on average and over time, active managers as a group fail to outperform; and even though some individual managers may be able to generate consistent outperformance, those active managers are extremely rare.”

White paper at p. 8.

The Indexer’s Philosophy

As a committed indexer I don’t proclaim that no one can consistently beat the market over long periods of time. Clearly these outliers exist (Buffet and Berkshire as a noteworthy example), and so do the investors that can spot them (Berkshire investors over the last 50 years). But I also know that there are outliers on the other side of the distribution—Bernie Madoff comes to mind—and a whole bunch of noise in between. And the data tells me that I’d have to be in a very small minority of the active-management fund population in order to consistently beat the market over my long-term time horizon. Prior to the widespread use of index investing, most individuals did their best to pick the “winning” funds and failed (as most do), and thereby failed to achieve the average returns of the broad market.

While the FI community has embraced index investing with a fervor that resembles a moral crusade (me included), the reality is that it is nothing more than a calculated and rational high-probability decision among competing investment alternatives. (And yes, as described in the entertaining blog post that also appeared in my inbox while writing these words, it’s boring.)

The Morphing Meaning of “Indexing”

I’m sure that the podcast host referenced above would argue vehemently that he has not changed course, and that he is simply making the case for intelligent indexing. (The other example he gave of out-performance was the “lobby index” described in this week’s Barron’s publication.) But moving assets to sectors or employing smart-beta strategies that seek to beat the broader market-cap weighted indexes is only a different type of active investing. Instead of rolling the dice with individual stocks or hot fund managers you’re looking to place a concentrated bet on the next hot sector or area of the market. This brings the same kind of risk and uncertainty as any other type of active management (i.e., the risk that you’re not as good at predicting the future as you think you are.) Vanguard agrees with me:

“Any strategy, in fact, that aims to differentiate itself from a market-cap-weighted benchmark (e.g., ‘alternative indexing,’ ‘smart beta’ or ‘factor strategies’) is, in our view, active management and should be evaluated based on the success of the differentiation.”

But I notice that they didn’t cite Joe Freedom in their white paper.

The apparent confusion over the concept of “indexing” became apparent to me after a recent discussion that I had at a meet-up of listeners to the Money for the Rest of Us podcast. The host of this podcast, David Stein (not the podcast host referenced above), falls into the category of an active-indexer in that he is frequently adjusting portfolio allocations to different asset classes while using predominantly index-type investment vehicles to do so. During this meet-up I struck a conversation with another listener who seemed to know his stuff, and at some point I noted that I enjoyed Money for the Rest of Us podcast mostly for the intelligent economics principles that David knows very well and for his entertaining stories that he uses to illustrate his ideas. I noted that I don’t use the premium feature that David offers to listeners for a fee because “I’m an indexer and I don’t alter my portfolio allocations very often.” (Or at all.) My conversation cohort replied, somewhat confused, that David is an indexer too because “he’s not in individual stocks.” True, as far as I know, but he also spends significant time and energy researching and tweaking his exposure to asset classes well beyond stocks and bonds, including gold, commodities, physical real estate, and maybe even Bitcoin. As a “lazy and complacent” index investor, I don’t want to play this game. It takes too much time and effort, and there is too much really good craft beer to be consumed. And my interpretation of the data (as well as intuition regarding these more exotic asset classes) tells me that I’ll likely spend more time and money (in fees) for the privilege of doing worse than the broad market of global stocks over the long haul. If this type of high-effort, high-fee, less-than-global-equities-return risk is present in a portfolio strategy, I consider it to be active . . . or at least active-indexing.

Beware Financial Advisors That Crap on Plain-Vanilla Indexing

Investment advisory and asset management is a huge industry with big dollars at stake in the effort to convince you and me that the smartest guys in the room can predict the future. Since Jack Bogle and Vanguard invented the index fund in the 1970s, Wall Street has attacked the practice as ineffective, under-performing, and even un-American. When this type of analysis (or ad hominem attack) is coupled with the invitation to pay for promised out-performance, be very skeptical. Indeed, in the podcast that prompted this post, the financial advisor declared something to the effect of “if you want to be an investor, not just a saver, call me.”  In the ten-plus years of listening to this previously trusted information source I had never heard him make such an overt solicitation.

Fifteen or twenty years ago when a fee-only financial advisor could use a low-cost indexing strategy to get superior returns for his clients at a lower cost he was likely viewed as a rogue genius by anyone who was objective and paying attention. That was when it was harder to do-it-yourself—even if only psychologically because not everyone was doing it (like today). Now that it’s commonplace, people are much more comfortable going it alone, and financial advisors do need to pay the bills. One option would be to look for other areas to prove your value as an advisor. Behavioral change related to spending/consumption and investing behaviors would seem to be low-hanging fruit, but it isn’t sexy, and many financial services professionals will undoubtedly conclude that “I didn’t go to Duke and Wharton for six years to teach clients how to stick to a budget.” That’s fine, but now you have to convince your clients and the market that the only place to really build wealth is through the investment management function . . . and for that you need a pro that can . . . actively index.

Keep Your Brain Turned On

Let’s be clear: I have my own concerns about the future of index investing, and I don’t intend to float along with the tide and not make my own critical assessment of the market and index vehicles specifically. I have this nasty personality disorder that leads me to believe that any time something is adopted by the masses it will ultimately be perverted. I saw a theory once that went something like this: all human endeavors start as a grass-roots campaign, develop into a big business, and ultimately degenerate into a racket. (A quick search through the Googles didn’t attribute this to anyone.) I’m not under any illusion that this can’t or won’t happen to the index-fund industry. There’s just too much money at stake for it not to be a real possibility.

The path of net money flows in the recent past is clear: big dollars out of active investment vehicles and into passive vehicles. So the herd is very clearly moving in our direction (the low-cost passive index direction). I don’t yet know what changes this will bring, but I do know it will bring changes. And I intend to keep my brain turned on and be ready to make changes if and when I need to. For now, at a time when a large majority of invested dollars are still being actively managed, there is enough activity to ensure a robust market for securities based on dynamic pricing. That means indexers like me continue to free-ride and earn larger (i.e., market average) returns for less in expenses.

Advice to Professional Financial Advisors

Wide-spread index investing should be scrutinized by financial professionals, especially those being paid to manage their clients’ money. But to refer to passive index investing that has earned annualized returns of 9.9% since 1965 as “inferior” based on a cherry-picked point of comparison to Berkshire Hathaway is disingenuous—clearly so when paired with a solicitation for money management services that appear to offer higher returns thru active indexing. (I will concede, however, that my foil in this piece has a point about indexing being “lazy.” I’ll own that. Proudly.) It strikes me as a desperate move by a self-interested party that has compromised his objectivity. My suggestion to anyone that butters their bread with money earned from advising others with respect to investment management: find a way to capitalize on the changing landscape by providing value in new areas such as behavioral change. “Behavioral change” is a fancy technical term that means “help your clients stop doing stupid sh*t with their money.” If you can double or triple your client’s savings rate you have likely helped him many magnitudes of order more than if you attempt to eke out an additional incremental 1-2% in annual portfolio returns—which as the data shows is highly unlikely in the first place.

Footnote: Isn’t it ironic that Warren Buffett has publicly stated that his advice to his wife will be to invest whatever amount of his fortune is left to her in an S&P 500 index fund?