Vanguard Successfully Debunks Some Myths and Misconceptions about Indexing

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At Index Fund Advisors, we are extremely pleased with the continued success of passive over active. According to a recent Vanguard Research Note1, for the six years ending 12/31/2013, passively managed funds including index mutual funds and exchange-traded funds (ETFs) experienced $1.37 trillion in net in-flows while actively managed funds only gathered $429 billion. Nevertheless, some persistent criticisms of indexing remain, and this paper takes them down one-by-one.

Myth #1: Indexing only works in “efficient” markets.

Contrary to popular belief, a financial market does not have to be efficient in pricing securities for indexing to be the correct choice for most investors. The purpose of indexing is to capture the return of a market at a low cost without regard to whether that market is efficient. Even if the targeted market were totally inefficient, all the active investors in that market (as a group) would still get the market return minus their costs. The passive investors would also get the market return minus their costs, but their costs would be substantially lower than the active investors. This finding of Bill Sharpe2 is often touted by John Bogle as the “cost-matters hypothesis”.

Two markets that the proponents of active investing often categorize as inefficient are U.S. small-cap and emerging markets equities. However, Vanguard found1 that 84% of active small-cap blend funds and 71% of active emerging-market funds underperformed low-cost index funds for the ten years ending 12/31/2013.

Myth #2: Who wants to be “average”?

This reminds of one of the early attacks on indexing as “un-American” because in all other endeavors, the harder you try, the better you will perform, and to be American is to always strive for the best possible performance. The fact of the matter is, however, that indexing usually results in a return that is well above the average of all investors because they cannot (as a group) overcome their costs. As Vanguard summarizes it, “Efficiently capturing the average returns of a market is far from ‘just average’ performance when compared with investors’ collective experience.”

Myth #3: You get what you pay for—Higher cost Higher ratings = Higher returns

Intuitively, we tend to associate higher cost with higher quality. Regarding investing, however, this idea gets turned on its head. As John Bogle said in a speech3 at the World Money Show, “First, in investing, realize that you get what you don’t pay for.”

Vanguard verified this to be true when they analyzed fund returns for the U.S. equity and bond market. Specifically, in every category they examined, the return of the median fund in the lowest-cost quartile exceeded the return of the median fund in the highest-cost quartile by substantial margin. As for whether star ratings have predictive value, Vanguard found that the average subsequent 3-year return was 1.23% lower for 5-star funds compared to 1-star funds.

Myth #4: Market-cap weighting overweights the overvalued [and underweights the undervalued]

This is sometimes referred to as the “Noisy Market Hypothesis” which takes for granted that at any given time there are some stocks that are “overvalued” and other stocks that are “undervalued”. Even if we did agree with this premise, we would take issue with the conclusion that market cap-weighting inherently overweights the overvalued stocks because the current price (or market cap) of a stock simply does not tell you if it is overvalued or undervalued. For example, Apple at a market cap of $539 billion has the same probability of being “undervalued” as does Papa John’s Pizza at $1.8 billion, so having relatively more Papa John’s than Apple in your portfolio does not give you a higher expected return beyond what  can be explained by exposure to risk. The mathematics behind this was thoroughly explained by Professor Andre Perold4 of Harvard Business School.

Myth #5: Index funds underperform in bear markets.

All too often, we have heard the canard that active managers do better in bear markets than index funds because they can make defensive moves while the index funds are forced to ride the market down. As with all these other fables, the data says otherwise. Vanguard found that since 1970, a majority of actively managed funds underperformed the market in four of the seven bear markets. In the SPIVA Scorecard of 12/31/20115, S&P Dow Jones Indices stated, “In the two true bear markets the SPIVA scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.” The table below provides the numbers:

Even when one has found a manager who outperformed in a particular bear market, the very low observed persistence of outperformance indicates that there is no reasonable expectation of outperformance in the next bear market.

To summarize, we commend Vanguard for doing an excellent job in making the case for indexing.

1Debunking Some Myths and Misconceptions about Indexing. Valley Forge, PA: The Vanguard Group, April, 2014.

2Sharpe, William F., 1991. The Arithmetic of Active Management. Financial Analysts Journal 47(1): 7-9.


4Perold, Andre F., 2007. Fundamentally-Flawed Indexing. Financial Analysts Journal 63(6): 31-37.