Why I Prefer Index Instruments

by: Lowell Herr

Why build portfolios using index investment vehicles such as index mutual funds or non-managed index ETFs instead of selecting individual stocks? An excellent question since the majority of individuals construct their portfolios using stock selection. Stock selectors are active investors as they hold the belief that through brains, stock analysis, technical analysis, or some other art form, they are able to outsmart the broad market. Based on study after study, this self-confidence is misplaced. This in no way states that there are no investors who can outperform the broad market or an appropriate benchmark. The probabilities of chance dictates such investors exist.

I posit many investors stick with their stock selection practices due to a form of the Dunning-Kruger Effect. They do not know how well their portfolio is performing with respect to an appropriate benchmark and/or they are unaware of the risk they are taking with their portfolio. How do I come to these conclusions? This is where I will rely on other sources. Let's begin with The Investment Answer, written by Daniel C. Goldie and Gordon S. Murray. In Chapter 4, page 41 they write,

The Efficient Markets Hypothesis asserts that no investor will consistently beat the market over long periods except by chance. Active managers test this hypothesis every day through their efforts to outperform their benchmarks and deliver superior risk-adjusted returns. The preponderance of evidence shows that their efforts are unsuccessful.

Where might we find some evidence? One recent source is Richard A. Ferri's book, The Power of Passive Investing. Chapters 5, 6, 7, and 8 are loaded with data showing the ineffectiveness of active mutual fund managers and the ability of investors to consistently select top money managers. On page 76 Ferri writes,

The only conclusion one can draw from this data is that active management, cannot compete against passive management in any asset class, style, or sector in the long run.

Ferri summarizes on page 92 of Power of Passive Investing, "Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That's a lot of headwind! A portfolio of index funds and market tracking exchange-traded funds is superior to active management. It's the most efficient way to reach your financial goals; that's the bottom line!"

Here are a few notable quotes from Andrew Hallam's Millionaire Teacher.

1) Index fund investing will provide the highest statistical chance of success, compared with actively managed mutual fund investing.

2) Nobody yet has devised a system of choosing which actively managed mutual funds will consistently beat stock market indexes. Ignore people who suggest otherwise.

3) Don't be impressed by the historical returns of any actively managed mutual fund. Choosing to invest in a fund, based on its past performance, is on of the silliest things an investor can do.

For more details, read Chapters 3, 5, and 6 of Hallam's book.

If you need further convincing, read Chapter 2 from The Elements of Investing, by Malkiel and Ellis. Here is one choice quote found on page 38.

Only a few managers beat the market. Since 1970, you can count on the fingers of one hand the number of managers who have managed to beat the market by any meaningful amount. And chances are that as more and more ambitious, skillful, hard-working managers with fabulous computer capabilities join the competition for 'performance,' it will continue to get harder and harder for any one professional to do better than the other pros who now do 90 percent of the daily trading.

Let me tell you of my own research conducted a few years ago. Using the Morningstar database of over 10,000 mutual funds, I wanted to know how many and which mutual funds were able to outperform the S&P 500 over three, five, ten, and fifteen-year periods. The fifteen-year requirement trimmed the number of mutual funds down to around 1200 as most funds were not operational fifteen years prior to the test. From those 1200 mutual funds, only 14 outperformed the S&P 500 and a few of the 14 funds were themselves index funds.

Who among us can select an actively managed mutual fund right now with any assurance it will outperform the broad market over the next fifteen years. Let me follow up that one of the funds that did better than the S&P 500 no longer has the same money manager and as a result has fallen on tough times.

I still hear the small investor telling themselves - I can do it. I don't have the same overhead as a professional manager. Nor do I need to hold cash in case of redemption's. Good luck. There will be a few successful investors, but can they do it over a 40-year lifetime of investing. If the pros cannot beat an appropriate benchmark, why do so many individuals think they can. It comes back to the Dunning-Kruger syndrome. Remember the saying - "Nobody knows more than the market."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.