Many Consider Index Investing To Be Truly Superior To Active Fund Management.

Are these claims true?

Index investing is very popular... primarily for two reasons.

But are these two reasons... reason enough?

Let me just share a few things with you.

And then... you be the judge.

At the heart of any argument... for or against index investing... lies the following question.

Should you rely on active or passive management?

Most mutual funds are managed by professional money managers (active management).

Before you invest - investigate.

~ Salmon P. Halle

The fund manager's job... is to decide what investments the fund will buy and/or sell.

The fund manager's goal... is to produce results in line with the fund's stated objective(s).

Index funds... on the other hand... do not function like this.

Instead... their portfolios merely mimic (passive management) the holdings of... some market index.

So which approach should you choose?

Active or passive fund management?

Before we go any further... I want to make something very clear.

I do not "have a dog in this race."

I do not "have an ax to grind" when it comes to index investing.

I do not care whether you use index funds or not.

Whether you prefer the index investing approach or whether you prefer investing in actively managed funds... in the long run... either approach will put you way way ahead of someone who never invested at all.

Or someone who invested only in bank CD's.

My issue is not in regard to index funds and index investing... per se.

Instead... my issue is with the "claims" that indexing proponents make.

They adamantly claim that index funds "always" beat actively managed funds.

That is simply... not true.

And so... I am morally compelled to speak out against such false claims.

That said... let's continue.

Proponents of index investing offer only two reasons for why they prefer index funds over actively managed funds.

  • Index funds produce higher returns.
  • Index funds are cheaper.

So is it true?

The claim that index funds make more money than actively managed funds... is definitely not true.

No doubt you have heard the following statement... "Index funds beat 80% of all actively managed funds."

Other statements claim that index funds always beat actively managed funds.

If there is academic or independent support for such claims... I have not seen it.

What we see depends mainly on what we look for.

~ John Lubbock

Normally what you do see... if anything at all... is selected comparisons for very short periods of time (3-5 years max.).

Such short time frames can be used to illustrate either index over managed or managed over index... take your pick.

Long term comparisons do not substantiate the above statements inferring superiority.

If index funds always beat actively managed funds... there would not be any actively managed funds.

The truth is... there have been periods of time when the performance of index funds (sometimes called no load mutual funds) have certainly been better than the performance of actively managed stock mutual funds.

At times they have indeed beat the vast majority of managed funds.

But this is definitely... not always true.

Likewise... there have been periods of time when managed funds have performed much better than most... if not all... index funds.

This also is... not always true.

The second claim... that index funds are cheaper than actively managed mutual funds... is true.

It is... however... irrelevant and pointless.

Paying lower fees does not necessarily produce higher returns.

Some of the most profitable mutual funds in history... with incredible track records spanning 25 years and more... are managed funds.

And some of these funds have some of the highest fee schedules of all mutual funds.

Mere performance is not what is most important.

What matters most is... risk adjusted performance.

And that is where indexers and index investing falls apart.

Index funds are always 100% fully invested in the assets of the index it is emulating... regardless of market conditions.

But fund managers have the ability to shift assets based on market conditions.

This is why index funds have higher betas than most other mutual funds.

But index proponents never talk about that.

When proponents of index investing allege that index funds are better than "actively managed" funds... they are, in fact, implying that index funds are "not managed."

They point to the fact that... index funds simply buy the stocks that appear on the index's list.

Now that is true.

But wait... who creates the list?

What actually happens is... an investment committee decides what stocks belong in the index.

If someone is deciding what stocks are in the index then how can it be said that index funds are not managed?

Whoever is managing the index is... by proxy... managing any index fund that emulates the index.

So let's stop pretending that index funds are not managed.

They are.

They are just very poorly managed.

The obvious next question is... "how" is the index managed?

Here's how the S&P 500 Stock Index is managed.

A committee decides what stocks belong in the S&P 500.

Then the committee decides how much of each stock to place into the index.

And this is where it gets interesting.

Rather than placing the greatest emphasis on stocks that it feels have the greatest potential for growth... the committee simply lists each company according to it's "market value."

Thus the larger companies receive more weighting in the index than the smaller companies.

The result is that buyers of index funds... end up investing a lot more of their money into the biggest stocks in the index than in the smallest stocks.

Although you will be buying 500 stocks... you will be placing perhaps 40% of your money into maybe 25 or so of them.

The remaining 425 stocks will get the rest of your investment. Many may only receive a few dollars of your investment.

Did you think you were obtaining broad diversification?

Does it make any sense to invest more money into a stock simply because the company is bigger?

Does being bigger mean it's stock price will grow any more or any faster?

The truth is...

The performance of the S&P 500... is not based on how all the companies in the index do.

The S&P 500's success... is based "only on how the biggest stocks" in the index do.

And there have been times when things get a little weird.

For example... in 2000 the S&P 500 fell 9.5%.

This occurred despite the fact that...

  • 57% of the stocks in the index rose in value.
  • 51% of the stocks in the index rose more than 10%
  • more than a third of the stocks rose more than 30%.
  • the average return for all 500 stocks was 14.5%.

That year... the stocks that did well were not high on S&P's list.

It was the big stocks that dragged down the overall index.

In my view... the S&P 500 is... not only a managed portfolio of stocks... but a poorly managed portfolio of stocks.

It would be more accurate to think of the S&P 500 as basically just another large cap stock fund.

And finally... what about taxes?

Some claim that index investing is tax efficient because of little or no trading.

And so... there should be little or no annual tax liability.

Though the stock turnover in index funds is typically less than that of most actively managed funds... this creates a hidden additional tax risk to index investors.

By not paying much in annual capital gains distributions... index funds are creating a massive future capital gains liability.

At some point in time taxes on these gains will be paid.

The question is when?

Since index funds generate smaller annual distributions... the annual tax liability is smaller.

However... this doesn't mean that your taxes are less... they are just less "for now". At some point in time index investing will be expensive.

According to Forbes... if lots of investors "run for the hills" the next time the stock market drops... index funds will be forced to sell significant holdings to raise the cash demanded by those departing investors.

Selling lots of shares will trigger a huge capital gain liability for the investors who remain.

It will not matter whether you have been in the fund for days or for years.

Everyone left will have to pay that whopping tax.

Again... I want to emphasize that... my issue is not in regard to index funds and index investing... per se.

Instead... my issue is with the "claims" that indexing proponents make.

Whether you prefer the index investing approach or whether you prefer investing in actively managed funds... in the long run... either approach will put you way way ahead of someone who never invested at all.

"Because It Matters"... Jim

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