Index Investing: Pluses and Minuses

This week's Barron's interview was with Burton Malkiel, author of the book A Random Walk Down Wall Street, professor at Princeton, champion of index investing and CIO at AlphaShares. There were many interesting comments and ideas.

In A Random Walk, Malkiel says, he was essentially advocating index funds - but there were no index funds back then. He says that "two-thirds of active managers are beaten by the indexes." He believes "even more strongly than I did in 1973 -- that most investors would be much better off having at least the core of their portfolio in a low-cost index fund."

We've had a lot of good debates here about passive investing in terms of what the best definition is and how effective it is or isn't. It is tough to argue against the effectiveness of indexing. If you save properly and have the correct asset allocation, you will capture whatever the market does and historically this has been sufficient. Note that saving and allocation issues are major issues from a practical standpoint, even if the theory is credible.

There are gaps in the theory, and for some the gaps are too formidable to make indexing right for them. There are two big issues I have with indexing. First, there appears to be no forward looking analysis whatsoever, just faith that whatever worked before will continue to work into the future. This is a big leap of faith in my opinion.

The other issue I would note is that indexing seems to completely ignore the concept of risk adjusted return. Indexing proponents might say that proper asset allocation addresses this, but I don't agree with that. To the extent that people are potentially their own biggest obstacle to long term success, there is something to be said for defensive strategies and not necessarily needing to capture the full effect of the market even in the good times (this would be a function of a high savings rate and living below your means).

A little later on, Malkiel notes that "technical analysis is really useless." That it is useless seems to be easily refuted time and again. I wholeheartedly agree that technical analysis is not infallible. TA is not perfect, but then nothing is. Malkiel concedes that with indexing one flaw is that you end up owning too much of the wrong thing at the wrong time (tech in 2000 and financials in 2007).

The last thing to note are his comments about why individual investors should stay away from hedge funds and other alternatives because they will "get the worst" of both. He also says that the 2 and 20 pay structure of hedge funds will go away.

I have never been a fan of illiquid investments (ex-real estate that you can afford) for individuals, and lately things haven't worked out so well for some of the better known institutions buying illiquid investments either.

I am all for moderate weightings in exchange traded, alternative asset products that help manage volatility as part of a diversified portfolio. Not all of them work as advertised, but I do believe the right ones can help. There are several ETFs and at least one ETN that are broadly in this category. IndexIQ seems to be the most committed to this space. They have launched two funds so far, tickers QAI and MCRO, and have another 12 or 13 in registration. The two they have that are actually trading are too new for me to draw any conclusion, but small exposure to the space is perfectly valid.

Comments

[Roger Schre...:]

Passive investing is investing in "hope" and hope is not an investment strategy. Hope is the belief that something will happen without your effort. Does that really sound like a prudent and realistic approach for assets; those assets you are saving and growing for your retirement. Passive investing is high risk; it is speculating and gambling with your future.

Active strategies, at least, give you a fighting chance.

To say that technical analysis is not infallible, is as unnessary as saying that it gets dark at night because the sun goes down.

I would be happy to challenge "any investor" that my active investment process will produce better (safer and bigger) returns than their passive approach.

Roger Schreiner
Schreiner Capital Management, Inc.
scminvest.com

Jul 06 12:48 PM

[bigmoney:]

probably passive indexing is good to capture trends in macro-economics. active investing might be more fruitful, but it requires high IQ, free time, and motivation to study dry material in during that free time. Thats a tall order for most folks.

Jul 08 01:03 AM