Blog Post

AEIdeas

I have frequently posted on CD about investing in passively managed index funds, which I think is a superior investment strategy for most investors after considering diversification, expenses, taxes, risk, and turnover. Some investment professionals, smart stock pickers, active fund managers, and hedge funds can certainly beat the market over short periods of time, but in the long-run it’s almost impossible on an after-tax, after-expense, risk-adjusted basis.

Princeton economist Burton Malkiel and author of the classic investing book (some refer to it as an investment “bible“) Random Walk Down Wall Street, has probably been the strongest proponent of the index approach to investing (along with Vanguard’s John Bogle), even though when Professor Malkiel’s book was first published in 1973 (it’s now in its 11th edition) there were no indexed mutual funds available! Around the time of the release of the 10th edition of Random Walk Down Wall Street in 2010, here’s what Malkiel told The Motley Fool about how well his investment advice has held up over a period of almost 40 years:

I believe that even more strongly [in passively managed index funds] than I did when I first wrote the book in 1973, when there were no index funds. What I have done with every subsequent edition is ask the question, was the advice right? Is it in fact the case that investors have done better with index funds? And every time I do it, including the data that I put together earlier this year, I find that two-thirds of active managers are beaten by a passive index and the one-third who beat the index in one year, are not the one-third who beat them in the next year. In other words, there is very little persistence in terms of excess performance. Sure, in any period there will be people who have beaten the market, but it is not the same people from period to period. So I would say to you that I feel even more strongly today in that thesis than I did when I first wrote it almost 40 years ago.

And here’s how Malkiel responded to a question from The Motley Fool about what he considers to be the biggest myth about the stock market:

I think the biggest myth about the stock market is that there are expert investors who can consistently beat the market. It just isn’t true. Now my view would be, because that isn’t true, at least the core of every portfolio ought to be indexed. Now fully understand that telling an investor that you can’t beat the market is like telling a 6-year-old that Santa Claus doesn’t exist. And anyone with a speculative temperament is going to say, “Look, I want to go and pick some of my own stocks.” And I think that is fine, and you can do it with much less risk if the core of your portfolio is indexed.

To further support Malkiel’s proposition that even expert investors can’t consistently beat the market, the chart above shows annual, pre-tax returns for the S&P 500 Index (via NYU Stern) versus the annual pre-tax returns for hedge funds (via Barclay Hedge Fund Index), which are probably managed by the most sophisticated and talented investment professionals around. And yet the average hedge fund under-performed the S&P500 Index in 10 of the last 13 years (and in each of the last 7 years), and generated only a 6.62% average annual compounded rate of return over the last 15 years compared to a 8.82% average annual return for the S&P 500 Index. (Related: Check out this very insightful article “Two hedge fund managers walk into a bar” by Morgan Housel of The Motley Fool.)

Update: Additional support for Malkiel’s investment approach comes from the SPIVA Scorecards published by S&P Dow Jones Indexes. For the five-year period through the end of 2014, only about 1 in 9 actively managed large-cap stock funds (11.4%) out-performed the benchmark S&P500 Index; and for the ten-year period through year-end 2014 fewer than 18% of active managers beat the S&P500. In 14 of the 18 different fund categories tracked by S&P Dow Jones Indexes, fewer than 20% of active fund managers were able to out-perform their benchmark index. In 10 of the 18 fund categories, fewer than 15% of active fund managers beat their benchmark.

From a previous CD post in the summer of 2014, I thought it would be a good time to feature these 17 quotations below about index investing, collected from various sources, investors, economists and fund managers:

1. “Building a portfolio around index funds isn’t really settling for the average. It’s just refusing to believe in magic.” ~Bethany McLean of Fortune

2. “The S&P 500 Index consistently outperformed 98% of mutual fund managers over the past three years and 97% over the past 10 years, ending October 2004. In two 30-year studies, the S&P 500 outperformed 97% and 94% of managers. In addition, only about 12% of the top 100 of managers repeat their performance in the following years. Therefore, it is not possible to consistently pick next year’s hot mutual fund manager.” From IFA.com

3. “Over fifteen years to 1998, on a pre-tax basis the Vanguard S&P 500 index fund outperformed 94% of general equity mutual funds and 97% on a post-tax basis. The post-tax average difference in annual performance was 4.2% in favor of index funds.” ~John Bogle, founder of Vanguard

4. “No matter where we look, the message of history is clear. Selecting funds that will significantly exceed market returns, a search in which hope springs eternal and in which past performance has proven of virtually no predictive value, is a loser’s game.” ~John Bogle, Founder of Vanguard

5. “A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund.” ~Warren Buffett, Chairman, Berkshire Hathaway

6. “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” ~Warren Buffett, Chairman, Berkshire Hathaway

7. “Economists, when faced with a conflict between theory and evidence, discard the theory. Stockbrokers discard the evidence.” ~Andrew Smithers and Stephen Wright, authors of “Valuing Wall Street”

8. “I own last year’s top performing funds. Unfortunately, I bought them this year.” ~Anonymous

9. “After taking risk into account, do more managers than you’d see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding ‘no.'” ~Eugene Fama, Professor at University of Chicago and Nobel Economist

10. “Why does indexing outmaneuver the best minds on Wall Street? Paradoxically, it is because the best and brightest in the financial community have made the stock market very efficient. When information arises about individual stocks or the market as a whole, it gets reflected in stock prices without delay, making one stock as reasonably priced as another. Active managers who frequently shift from security to security actually detract from performance (vs. an index fund) by incurring transaction costs.” ~Burton Malkiel, Professor, Princeton

11. “The revenge of Vanguard founder John Bogle continues apace. As investors figure out that they are not good at stock-picking or managing trades, they have also learned that most professionals are not much better. Paying high mutual fund expenses to a manager who under-performs a benchmark makes little sense. This realization has led to the rise of inexpensive exchange-traded funds and indices.” ~Barry Ritholtz

12. “All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage. Unless you were fortunate enough to pick one of the few funds that consistently beat the averages, your research came to naught. Thereʹs something to be said for the dart‐board method of investing: buy the whole dart board.” ~Peter Lynch, Legendary Manager of Fidelity Magellan

13. “The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors. In fact, one of the reasons that actively managed equity funds under‐perform stock index funds is because they are spending so much money to advertise — money that otherwise would be invested on behalf of the mutual fund shareholders.” ~Internet Advisor, ʺThe Motley Fool ʺ

14. “If active and passive management styles are defined in sensible ways, it must be the case that: 1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and, 2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.” ~William F. Sharpe, Professor of Finance, Nobel Laureate

15. “Indexing is a marvelous technique. I wasnʹt a true believer. I was simply an ignoramus. Now I am a convert. Indexing is an extraordinary sophisticated thing to do. If people want excitement, they should go to the racetrack or play the lottery.” ~Douglas Dial, Portfolio Manager of the CREF Stock Account Fund, largest pension fund in America

16. “Index funds should outperform most other stock‐market investors. After all, investors, as a group, can do no better than the market, because collectively we are the market. Most investors, in fact, are destined to trail the market because we are burdened by investment costs such as brokerage commissions and fund expenses.” ~Jonathan Clements, Columnist, Wall Street Journal

17. “It’s unlikely that you’ll spot many dog-eared copies of A Random Walk floating amongst the Wall Street set (although bookshelves at home may prove otherwise). After all, a “random walk”–in market terms–suggests that a “blindfolded monkey” would have as much luck selecting a portfolio as a pro.” Amazon.com review of the 10th edition of “Random Walk Down Wall Street.”