Originally published on Oct 22, 2014
This is the debate that has been burning since the advent of index funds. It has recently been reignited by a public argument between Jack Bogle of Vanguard and James Moore of Pimco. It's the question all ordinary investors must face at some time during their lives: should I index?
I can't and won't answer that question definitively, partly because I happen to believe both strategies are potentially viable. While I do believe that the answer for most people is that indexing is right, I still would like to point out to some of the more stringent index fund partisans that if you are going to index, it is still important to understand how it is you make money doing it. Here are some of the key points indexers often forget.
First, it is widely overlooked on all sides that passive indexing relies on work of active investors. Any index's value is dependent upon the value of the securities that make up that index, and it is the investors who trade those securities who determine their value. Somewhere out there, active managers have to be doing their homework, or the index loses all of its efficient properties that allow a passive investor to make money. An index is no more than the aggregation of its constituents and a fair value for the index is dependent on accurate values for each of the index's component parts.
Second, it's often cited that something like 80% of managers fail to beat the market. Unfortunately, there are a few problems with these statistics. The most common mistake is making a comparison to the wrong benchmark. Too often, every mutual fund is just compared uncritically to the S&P 500. A corporate bond fund, for example, has no reason to be compared to the S&P 500. The same applies to a dividend-focused fund or any fund with a special focus or strategy. Sometimes you will see bear funds, which for hedging purposes are specifically designed to move in the opposite direction of the market, listed among those funds that did not beat the market, even when all appropriate measures show that the fund is managed quite well.
Another weakness of this type of study is that it often accounts only for returns. That is, there is no adjustment for risk. One advantage of active investing is the wide spectrum of nuanced investment strategies that are not easily comparable to an index sometimes because they seek to mitigate downside risk at the cost of higher returns.
Of course, one should never forget that the index is, by definition, the average performance of all managers. It is not mathematically possible for everyone to beat the average. So while individual managers can certainly be blamed for being consistently below average, it is not in any way a criticism of the industry that some (or even most) managers are below average.
The next point to understand is that indexes are constructed arbitrarily. Who decides what belongs as part of the index? Who decides the weighting? Some strange authority with some arcane process often decides the largest companies should receive the largest weighting. Why do it that way? Again, it's arbitrary. Nothing about that mechanism inherently improves returns or minimizes risk. Why, then, if a particular fund sometimes beats the index and sometimes does not, is it the fund that is considered inconsistent and not the index. A random fund is arguably just as reasonable a baseline as one of the major indexes. Moreover, because of the arbitrary decision-making that goes into constructing an index, there's no particular reason to believe that the benchmarks we use for indexing are optimal even as a passive investing strategy.
Finally, remember that even if you use index funds, you haven't eliminated all of your investment decision-making. How much of your portfolio do you allocate to long-term Treasuries? Should you buy gold? What are mid-caps anyway? These kinds of questions represent real decisions that all investors must face, and at least some of the answers will change throughout a person's life. So, although you may not know which fund will outperform this year or next, you also don't have the first clue about which asset class will outperform. (Ironically, it is usually indexers who are the biggest believers in using past performance to predict future results.) At the end of the day, the one thing you can know for sure is that you will not always be in the right place at the right time. Whichever route you choose will unavoidably require research and effort to do the job well.