#290 Stop Trying to Beat the Market: Use Index Funds

Stop trying to beat the market, because you can't. That sage advice comes from investment legend Charley Ellis, who has been keeping tabs on the debate between active and passive investment management for five decades. In his new book “Index Revolution: Why Investors Should Join it Now” Charley argues that indexing is the most efficient and cost effective way to achieve your long term financial goals. He states it clearly: “The stunning reality is that most actively managed mutual funds fail to keep up with index funds.”

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Ellis founded Greenwich Associates in 1972, creating a financial industry consulting firm that would become a go-to resource for the biggest fund managers and Wall Street firms. One of his many claims to fame is that he was the first industry insider to publicly proclaim that most active portfolio managers do not keep up with the benchmarks they are trying to beat, and that investors are better off in low-cost index funds. That admission occurred in 1975, when he wrote a timeless article, titled The Loser’s Game. In the article, he explained the quandary that active managers face and quantified their disappointing results. It was the same year that Vanguard launched the first index mutual fund. In addition to writing and talking about the industry, Charlie serves on as an Investment Committee member of Rebalance IRA.

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Join the Index Fund Revolution!

When he entered the investment world fifty yeas ago, Charles (“Charley”) Ellis fund that diligent financial analysts and portfolio managers could routinely outperform the stock market. But as the investment industry changed, information became ubiquitous and institutions replaced individuals, it has become “unrealistic to try to beat today’s market.” I recently had the pleasure of talking to Charley about his amazing career and his new book “Index Revolution: Why Investors Should Join it Now”. The book and the conversation left me even more convinced that investors are spinning their wheels using anything but index funds to achieve their long-term financial planning goals and objectives.

It is quite stunning to hear this message from a man who began his life on Wall Street in the early 1960’s as an analyst and then as a financial industry consultant at Greenwich Associates, the firm that he founded in 1972. Perhaps because Charlie became a go-to resource for the biggest fund managers and Wall Street firms, his early view that most active portfolio managers could not keep up with the benchmarks they are trying to beat -- and that investors are better off in low-cost index funds – was so fascinating. That admission occurred in 1975, when Charley penned the now-prescient article “The Loser’s Game”. His view about the virtues of indexing has become stronger and clearer 40 years hence.

In his 18^th book, Charley is beating the drum for index funds. “The stunning reality is that most actively managed mutual funds fail to keep up with index funds.” The most recent evidence from S&P Global proves the point: the S&P Indices Versus Active (Spiva) scorecard shows that 90.2 percent of actively managed US funds failed to beat their benchmarks, when their returns are calculated net of fees.

These types of reports have been available for years, yet index or passive funds still only account for a third of mutual fund assets. Sure, that’s up from a quarter three years ago, but a majority of individuals and professionals, some of whom owe fiduciary duties to their clients, “refuse to accept the objective data or insist on looking past it.”

Why do people delude themselves about beating the market, when as Nobel Laureate in Economics Daniel Kahneman, notes “They’re just not going to do it. It’s not going to happen.” Maybe investors want to believe that someone, some firm or some algorithm can beat the market, because the industry has told them that it is possible.

Early on, the asset management business condescendingly proclaimed that “indexing was for losers” and that investing in an index fund would be tantamount to confining your performance to just “average”. The industry’s marketing tactics has evolved, but even today, companies make big ad buys and trot out their analysts to tout “market-beating” funds, when the plain fact is that over time, they will not deliver consistent market-beating performance.

Charley notes that in making their case for active management, these folks rarely mention risk, nor do they adjust their data for taxes. Even the term “passive” can invoke a subliminal, negative connotation. After all, “Who wants to be passive?” asks Charlie. “Nobody will ever know just how much harm was done by wrapping the term passive around investing.”

Perhaps the most damning outcome of spending time and energy focusing your efforts on the fool’s errand of finding the market beating investments is that doing so can divert your attention from the more important financial planning issues in your life. Charlie writes that “Indexing simplifies everything,” and enables people to concentrate on “developing a balanced, objective understanding of themselves and their situation.” Amen.

Buy What You Know: A Dangerous Investment Strategy

Legendary investor Peter Lynch, whose investment management skills helped attract billions of dollars into the Fidelity Magellan Fund from 1977 until 1990, once famously advised small investors, “Buy what you know.” The concept was simple: if you buy what you understand, you are less likely to be led astray.  While it sounds pretty easy, there are some serious flaws with the “Buy what you know” investment strategy. According to Blackrock’s Russ Koesterich, while the Lynch saying sounds reasonable, it can lead some to create a portfolio heavily concentrated in local companies. Koesterich notes, “The fact that a company is headquartered in my hometown probably doesn’t make me any better qualified to judge its investment prospects.”

Even if you were trying hard not to be local, buying what you know may lead to rough results. For example, if you were an average consumer/investor looking to assemble companies that are familiar to you, these are some of the stocks you might choose and their year to date performance through July 25th:

Amazon.com (-18.8%), AT&T (+1.1%), Bank of America (+0.1%), Bed Bath & Beyond (-22.1%), eBay (-3.8%), Facebook (+37.6%) General Motors (-14.2%), LinkedIn (-18.2%), Staples (-30.8%), Wal-Mart (-3.5%). Sure over the long term, these companies are likely to do fine, but while you are spinning your wheels trying to “buy what you know”, you could have simply purchased an S&P 500 index fund, which during the same time horizon, was up 7 percent.

Buying what you know may have worked for a couple of individual companies (think of those early Apple users or those who stumbled into a store like Home Depot in the mid-1980’s), but trying to identify a dozen or so stocks in different industries to create a diversified portfolio is very difficult to achieve. Individual stock picking isn’t hard just for retail investors; even pros that oversee managed mutual funds have a tough time consistently beating the index against which they are compared.

S&P Dow Jones Indices issued a research report, which found that not many managed funds were able to consistently reach the top quartile of performance over five successive years. In fact, just 0.7 percent of the funds can stay above the fray for five years.

The good news is that investors are finally embracing the simplicity and strength of index funds, as they realize that it is very difficult to beat the index after factoring in costs and fees. According to the Financial Times, the world’s largest active fund managers, Lynch’s beloved Fidelity Investments and Capital Group, which operates American Funds, are losing out to index funds. “Figures compiled for the Financial Times by Morningstar show that investors withdrew a net $3.5 billion from Fidelity’s US funds in the six months to the end of June, while Capital Group’s American Funds managed inflows of less than $600 million. That compared to $64 billion flowing into Vanguard.”

This is not to say that investors will avoid making mistakes if they use index funds. According to the St. Louis Federal Reserve Bank, the average equity mutual fund investor, whether in a managed fund or an index fund, “tends to buy when past returns are high and sell otherwise.  This is called return-chasing behavior.” There is a steep cost to this behavior: it costs the average U.S. mutual fund investor to “miss around 2 percent return per year, which is very significant.”

How do you avoid return-chasing behavior? It’s the same old mantra: start by building a diversified portfolio, because as Koesterich observes, “over the long term, all the evidence still suggests that diversification – by asset class, geography, and sector – leads to better portfolios; portfolios that produce better returns per unit of risk.” That portfolio should factor in your risk tolerance and time horizon and you should keep expenses low with index funds; and rebalance the portfolio quarterly. Despite the lack of a catchy saying, this seemingly boring philosophy actually works!