Since the mid-90’s there has been an ongoing debate waged between “passive indexing” and “active management” of portfolios. The primary point of contention is “why pay a manager a fee to actively manage a portfolio when [x%] of managers fail to beat an index fund over [x period].” On the surface, this certainly sounds like a reasonable argument for ditching all of your actively managed mutual funds and buying an index fund. However, is that really the best thing for you to do?
A recent article by George Sisti entitled “Whack-a-mole fund managers can’t beat index funds” is a good example of the overall debate. He states;
“Proponents of active management claim that gifted managers can identify stocks that will rise in price and shun those that will decline. They can sell stocks in advance of any serious market decline and re-enter the market before the rebound, thereby outperforming their benchmark index. Let’s look at a recent report that debunks these claims.
Standard & Poor’s recently released its year-end 2013  S&P Indices Versus Active Funds (SPIVA) Scorecard that compares the performance of actively managed mutual funds to their S&P benchmark indexes. For the five years ending on Dec. 31, 73% of large-cap domestic funds, 78% of midcap funds, 67% of small-cap funds and 80% of REIT funds underperformed their benchmark indexes. Almost two out of three actively managed domestic stock mutual funds underperformed the S&P 1500 total stock market index over the past five years.”
There you have it. Clear evidence that you should just buy an index fund, shut up and go home. However, there are several issues with the analysis.
First, there is NO fund manager alive that can beat an index fund every year, year-after-year, over a long time period even if they simply mimicking the index. This is clearly shown by comparing the Vanguard S&P 500 Index fund as compared to the S&P 500 Index.
The differential in performance over time is due to the advantages an index has over a fund. (For explanation read:Â “Why You Can’t Beat The Index)Â An index:
- Has no trading costs
- Has no expenses to pay (Employee related costs, building and infrastructure costs, etc.)
- Pays no taxes
- Benefits from share buybacks
- Benefits from the substitution effect
- Does not have to compensate for redemptions or liquidity flows
You get the idea. Like a Unicorn, the benchmark index is a mythical creature that only exists in our imaginations. Yet, the index is used as a point of comparison to berate investors into competing for a prize they can not win. As I have stated in the past:
Comparison is the cause of more unhappiness in the world than anything else. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. Social comparison comes in many different guises. ‘Keeping up with the Joneses,’ is one well-known way.
If your boss gave you a Mercedes as a yearly bonus, you would be thrilled—right up until you found out everyone else in the office got two cars. Then you are ticked. But really, are you deprived for getting a Mercedes? Isn’t that enough?
Comparison-created unhappiness and insecurity is pervasive, judging from the amount of spam touting various enlargement procedures for males and females. The basic principle seems to be that whatever we have is enough, until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to remarkably bad decisions.
Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus. If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that “everyone else†made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions which further detracts from investor returns. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage creating more revenue for Wall Street.
