Devouring the News

From the Message Boards: Index Funds Disciples Duke it Out

Devouring the News
Jim Wiandt
One invests only passively but defends active funds, while the other admits to bouts of market timing but gives no quarter to active fund managers.
The Fundamentalist

Following is a recent letter exchange Jim Wiandt (the Managing Editor at IndexFunds.com, pictured above left) had with Jason Zweig (The Fundamentalist at Money.com, pictured above right). It was posted to the Index Funds Seminar discussion board with Zweig's consent.

This particular exchange originated as Wiandt's response to a recent Zweig article on Longleaf funds. The Fundamentalist, it seems, while a hardcore indexer himself is also an avid defender of the active clan. You know where IndexFunds.com stands.

Jim Wiandt Regarding your article today: Intellectual integrity or not, it's all a racket, and a losing one at that. It is very easy to pick SOMEONE who has beaten the market over the last 10 years. It's nearly impossible to find someone who's done it over 25. And how could you have possibly known to have picked the lucky winner ahead of time? You know the statistics as well as I...active fund managers are saddled with fees, and 75 or 80% of them (75 or 80! - and these are pros) get beat by the market.

There's a perfect thread on exactly this point on our Main discussion board today. Some poor sod comments on our article about John Bogle's recent $25 bet win w/ an active manager. He says Bogle is just lucky he didn't bet William Miller III at Legg-Mason Value. Meat for the resident bears, obviously...My money says L-M goes the way of Longleaf.

The Fundamentalist Anyone who advocates active management on the basis of performance is a moron. But anyone who says that active management serves no purpose whatsoever, simply because its promises of outperformance are illusory, is naive about human nature. (I know, because I said it myself in several speeches a few years ago, and I now realize I was wrong.)

The challenge for the typical investor is not to find the investment vehicle with the best performance, but rather to prevent himself from being his own worst enemy--from buying high and selling low, from trying to time the market, from thinking he knows which sector or segment of the market is heading where. A buy-and-hold investor in even a pretty poor actively managed fund is all but certain to make more money than an itchy-fingered index fund investor. You make a mistake in assuming that because the index fund is a superior investment, all the people who own it are superior investors. Index funds have no inherent magical power to increase the IQs--or the emotional staying power--of their owners. It's investors, not investments, that make or lose money.

The FundamentalistAs reams of postings on your own boards show, index fund investors are not exempt from these same psychological vulnerabilities just because they avoid active funds. The percentage of your visitors who believe they know where the market is headed, which sectors will do better, which Barra quadrant will beat the others, is startlingly high. These people are kidding themselves, and while it's certainly cheaper to kid yourself with an index fund, that doesn't make it a good idea.

You seem to be interested in how investments behave; I think how investors behave is far more relevant. The question, then, is whether there are ways that investment management firms can help investors capture a greater proportion of whatever return their funds generate. There are a handful of active funds that put a great deal of effort into treating their shareholders fairly and making them feel they are part of a community of people who think alike about investing. That feeling of belonging is intangible, unquantifiable, and has no place in the textbooks on modern portfolio theory. But anyone who knows one whit about psychology knows that it is very important--and it is vital and valuable to investors.

Longleaf is one of about a dozen firms (out of close to 700 total!) that treat their shareholders like intelligent partners. Someone who understands what his fund managers are thinking, and can tell that they care about his interests, is a helluva lot more likely to stay the course than the typical investor at a fund with "hot" performance. In fact, odd as it sounds, he may even be more likely to stay the course than many index fund investors.

You and I both know that many index fund investors are doing the right thing for the wrong reason: they are chasing performance, and when it goes away so do they.

I would have praised Longleaf just as highly if its performance had always been as bad as it has been lately. Performance (as most people measure it) has nothing to do with why I wrote about Longleaf. Looking at the time-weighted returns of portfolios is a superficial way to assess quality. Instead, we should look at the dollar-weighted returns of each fund's population of investors. The handful of active funds that care about this issue are working hard at improving the dollar-weighted returns of their clients; just by mathematics alone, that's easier for little Longleaf than it is for giant Vanguard.

In short, I'm arguing that superior active management really involves managing investors, not investments. Indexing every dollar is the only optimal choice for a purely rational investor. But most people are a big sloppy clump of conflicting emotions, and that's why active management will always dominate most fund investors' portfolios. If I wanted my money managed actively, which I don't, I'd sure as hell rather give it to people who care about my money as if it were their own than to people who care only about the doomed and desperate attempt to hit the top of the performance chart...any performance chart...for any period...however brief.

The FundamentalistThat's why I praised Longleaf: because they take the high road and the hard way, when most other active managers take the path of least resistance and greatest reward (for themselves!).

Please don't waste your breath "educating" me about the superiority of indexing. I've been well aware of it, and advocated it steadfastly, for nearly a decade.(See, e.g., Bogle, "Common Sense...," pp. xvii, etc.) While indexing is financially superior for everybody, it's not emotionally right for everybody.

The Fundamentalist I'm glad you're coming to see that we agree about more than you thought we did. We still disagree about a few things. I don't think large growth was or is the only overvalued part of the market. I can count on one hand what's NOT overvalued: inflation-indexed bonds, emerging-market equities, emerging-market bonds, and REITs. Everything else, by my lights, is overvalued, mostly by a ton. Small, large, growth, value, US and developed foreign stocks--all at or near record valuations, and all likely to produce below average returns before long.

But, unlike you, I don't act on my convictions about market valuations. Sure, I think everything's overpriced, but I refuse to move my money around based on that belief. Why? Two reasons: 1) I've tracked my forecasting record for nearly 15 years, and it's about as good as anyone's, i.e., it sucks. 2) Even if I am right--objectively right, mathematically right, proveably right, demonstrably, incontrovertibly right--well, there are 80 million other investors in this country. I get one vote; they get 80 million. They're gonna win against me every time.

So all I do is dollar-cost-average into my index funds every month, with the same repetitive rhythm as a blind man tapping his cane as he walks along an endless sidewalk. If the sidewalk goes uphill, then--tap, tap, tap--I follow it uphill. If it goes downhill, then--tap, tap, tap--I go right along with it. It is a permanent autopilot portfolio; so far as I can tell, I have completely purged all emotion from my investment life. I refuse to judge my investment success by how a bunch of strangers are doing; if someone else wants to put all his money in Verio, VISVX, Veritas, or VEXMX, God bless him.

I know I do not know, cannot know, and never will know which stocks or sectors will do best in the future. If someone else thinks he does, he's welcome to his delusion. And I couldn't care less about other people's returns; if his delusion pays off for a while, I'm happy for him. Meanwhile, I'm always going to get 99.8% of whatever the market offers, and that's good enough for me. In fact, I've made no changes to my investing plan in six years and I doubt I ever will(barring drastic changes in my circumstances).

The other point I'd make is that you are dead wrong when you doubt that active management will retain the lion's share of fund investors' assets. Human beings have evolved as pattern-seeking animals, and any fund manager who can beat an index fund for more than a few weeks at a time is always going to be viewed as a genius, even though you and I know he's done nothing more than flip a coin the same side up a couple of times. The great cognitive psychologists Danny Kahneman and Amos Tversky have called this "representativeness," or the law of small numbers: the belief that a partial data sample accurately reflects the distribution of the total sample. A quarter-century of psychological research shows that this is simply how human beings think: it's human to believe that even short streaks will persist for a long time. That means investors will forever believe that hot streaks in the recent past have predictive value for the future, and it means indexing will never dominate the fund business.

The FundamentalistWhat's more, people are hard-wired to confuse ex-post probability with ex-ante probability. The Bill Miller fan you mentioned says something like this to himself: "Miller has beaten the S&P 500 for nine years in a row. Hey, anybody can do this math. Assuming binary outcomes- either a fund manager beats the S&P, or the S&P beats him--then the chance of any single fund manager outperforming for nine straight years is 2 to the 9th power, or one in 512, meaning that it's 99.8% certain that Miller's raw return was due to skill."

But what this fellow is forgetting is that there were, according to Morningstar, roughly 628 stock funds benchmarkable to the S&P at year-end 1990--meaning that the probability that one of them would beat the market over the ensuing nine years was 100%. By random luck alone, assuming each of the fund managers was flipping coins blindfolded, it was absolutely certain that one of those 628 funds would beat the S&P for nine years in a row. Viewed this way, the miracle is not that Bill Miller exists, but that there aren't a dozen of him.

Because people fixate on ex-post probabilities, and pay no attention to ex-ante probabilities, and because people can't help but believe that yesterday's hot streak says something about tomorrow, hope will always spring eternal. Active funds will always have more money in them than index funds. The human mind changes far too slowly for it to be any other way. But the beauty of being an index-fund investor is that the folly of other people is their problem, not yours. I don't have to buy Lotto tickets just because everyone else on my block is buying them.

Jim Wiandt Just a couple more things on the last letter:

Probabilities: on a coin flip basis the odds of one of the 628 fund managers would beat the index nine years in a row is NOT 100%, CAN NOT be 100%. Theoretically, every single manager could flip a loss every single time. I'll let the board have a go at the other numbers. Other issue - 99.8% chance that skill was involved in Miller's performance. I don't dispute that skill was involved (well, I could, but that's not the main point) All I am saying is that - sure 10 years from now someone running a fund is going to look like a wizard. How can we possibly be expected to pick the right one? The odds clearly favor you if you steer clear of the whole active fund racket and go long, very long.

The Fundamentalist You're right about the 100% odds. "Pretty close to 100%" would have done the job a little better. (I do have a habit of typing a little faster than I'm thinking.) And sure, I agree (especially because I've spent some time with him); Bill Miller has shown he's been skillful, at least so far. But I don't recall anybody saying that back in 1990; in fact, even most well-informed fund investors never heard of Bill until a couple of years ago, after most of his current streak was already behind him. (I don't think I noticed him myself until 1995 or so.)

I personally think the odds of identifying a market-beating fund manager in advance are very close to zero; they're not quite zero, because you might blunder into him by sheer accident. If you weren't really looking for Bill Miller in 1990, you might have found him by mistake. But if you tried looking for him, that would have reduced your odds of finding him to absolute zero. You would almost certainly have bought a biotech fund instead.

Jason Zweig is a columnist for Money magazine. Jim Wiandt is Managing Editor of IndexFunds.com

[:Author:]IndexFunds.com Staff