Watching Grass Grow

The Downsides of Indexing?

Watching Grass Grow

A recent article on MarketWatch by J.J. Zhang offers up several criticisms of indexing that we will answer here. Zhang starts with the usual positive attributes of indexing, such as simplicity and diversification - and then begins his attack:

“With several studies showing how simple buy-and-hold index strategies outperform most active hedge funds, it seems almost too good to be true. After all, you just buy a couple of funds, without having to do research or read financial statements, and you’ll beat everyone including seasoned professionals! However, there is a basic economic rule: there is no such thing as a free lunch.”

The first thing we noticed is that Zhang went straight to hedge funds and made no attempt to defend actively managed mutual funds. Perhaps he is conceding that they are a lost cause? The cash flow data from Morningstar certainly points in that direction. Regarding the free lunch, as we noted in this article, it is the people who believe that they can hire an active manager to beat the market on their behalf who are demanding the free lunch.

Zhang’s criticism of indexing takes an almost bizarre turn when he talks about fees:

“First, it’s important to clarify what those index fund versus active fund comparison studies really say. While it is true most hedge funds underperform index funds overall, a large cause is due to fees, the 2% of assets and 20% of returns that most hedge funds charge. Calculating returns before fees significantly improves the performance comparison of active funds and, in many cases, show alpha gains.”

From this, Zhang infers that people picking stocks on their own may outperform market indexes since they don’t have to pay the 2 and 20 to a manager. That retail investors can expect to perform as well as investment professionals (before costs) is ridiculous on its face, especially given the terribly non-level playing field that is today’s market. Naturally, Zhang cites Warren Buffett as an example of someone who beat the market, implying that his returns are attainable for investors who simply do their homework. As we have noted in a prior article, Buffett’s returns came not just from his stock picking ability but the management contributions that he made to the companies he acquired. Next, Zhang pulls out the tired criticism of indexing as settling for average.

“Passive index funds will only give you average results. Since an index is the combined average gain and loss of its components, you get the outperformance of good companies along with the underperformance of the bad. A comparable analogy: Are you willing to take a job that will only pay you the average U.S. salary (approximately $50k per household), no more and no less? You will not be poorer than 50% of the population, but you will have no hope to do better.”

This argument is the same one that was used against John Bogle in 1976 when he founded Vanguard and introduced the first index fund available to retail investors. Fidelity Investments Chairman Edward Johnson stated point blank that his company had no intention of joining this nascent movement: “I can’t believe that the great mass of investors are going to be satisfied with receiving just average returns. The name of the game is to be the best.” Ironically, Fidelity is now one of the leading providers of index funds. Our answer to this criticism is to note the conclusion reached by repeated studies that the market return is not simply average but is superior to the return achieved by the majority of investors. One such study is annually produced by DALBAR, Inc., a leading financial services and market research firm. The results are illustrated in the chart below:

 

Finally, Zhang’s comparison of indexing to taking an average job is spurious at best. The job that anyone takes is largely a function of their human capital, over which they can exercise a significant degree of control.

Another tired criticism invoked by Zhang is the idea that indexing leads to owning large positions in over-valued stocks.

“Pure indexing focuses on owning everything regardless of value. Though it removes the emotions and guesswork that often accompany attempts to fairly evaluate price, there are times when this can work against you. Many saw the sky-high valuations of the dot-com bubble in the late 1990s and the recent housing bubble. Pure indexing would have kept pouring money into those sectors regardless of valuation. This indiscriminate buying can come back to bite you.”

Unfortunately, active investors as a group had the same positions in the same proportions in these stocks as did the owners of market index funds. As we have pointed out many times, indexing is not limited to owning a market portfolio. Combining international diversification with tilting towards small cap and value stocks can mitigate the damage done by US large cap growth stocks that suffer a substantial drop in value, as happened in the dot-com bubble. This brings us to Zhang’s final criticism of indexing as lacking clear instructions for proper implementation:

“While many indexers disdain the idea of trying to pick winning stocks, proclaiming it impossible, the same problems appear when picking how to index. Do you index the entire world? Only the U.S. market? Large-market caps only or all? What about natural resources, commodities, real estate? And what allocation do you assign to each?”

Our answer to this one is simple. We agree that most investors should not try to do this on their own, and this is where a competent passive advisor can provide invaluable assistance. An advisor who has deeply studied the returns data of many asset classes can construct a risk-appropriate, globally diversified portfolio of index funds designed to capture the dimensions of returns offered by the financial markets. To get started in finding a portfolio of index funds that is appropriate for you, please take IFA’s Risk Capacity Survey or call us at 888-643-3133.