Old School Investing Ain’t Dead Yet

Passive investing rules. Mutual funds have become musty relics. Right? 

Not yet. Not by a long shot.

Index funds tracking the S&P 500 have grown at warp speed. By the end of 2020 they held assets totaling $5.4 trillion. Yet significantly more, over $8 trillion, is invested in actively-managed funds benchmarked to the S&P 500. Investor hopes spring eternal.

As for old-fashioned mutual funds, the WSJ reports  fund assets total some $21 trillion, far exceeding the $6.2 trillion in ETFs.  

In time the old order will indeed give way to the new. Already, early adopters are bypassing ETFs and turning to non-fungible tokens and cryptocurrencies. Reminder: if clients want to wager on crypto, make sure they consult their astrologer.

John Bogle (1929-2019)

“In investing, you get what you don’t pay for. Costs matter. So intelligent investors will use low-cost index funds to build a diversified portfolio of stocks and bonds, and they will stay the course. "

The Generosity of a Reformed Stockpicker

“After trying and failing to pick stock winners himself,” a retired ophthalmologist in Washington, D. C., “made his fortune by investing in the funds in the Standard & Poor's 500-stock index.”

Unmarried and living modestly, the retiree has used the fruits of his investing for philanthropy, dispensing millions to area charities. He agreed to tell his story to The Washington Post “to encourage others to invest wisely, research thoroughly and support those doing good work that will make a difference in peoples’ lives.”

Will the publicity cause the wise indexer to be inundated with requests for handouts? Not likely. He says he “would never donate to an institution that approached him first.”

Massacre of the Stock Pickers

Investors who use index funds to invest in the stock market usually do better than stock pickers. That's become conventional wisdom.

According to new 15-year data in SPIVA's 2016 scorecard of stock fund performance, "usually" should be changed to "almost always."

Fewer than one large-cap stock fund in ten matched or beat its benchmark over the last fifteen years. More than 92% underperformed. 

Some say indexing itself has dulled the price moves of large caps, making stock pickers' job harder. Perhaps the pickers did better with mid caps? No, they did worse. A whopping 95% of mid-cap funds underperformed. So did 93% of small-cap funds.

Note that some mid-cap and small-cap funds may have beaten the S&P 500 even though they fell short of their more challenging benchmarks.

If actively managed mutual funds can't  beat the market, can highly-compensated hedge fund managers do better? That's the theory Warren Buffett put to his now famous test.  He bet that, over ten years, Vanguard's low-expense S&P-500 index fund would outperform a portfolio of five funds of funds, invested in more than 100 hedge funds. After nine years the results are clear: Another massacre of the active investors.

Buffett observes that the defeat was virtually pre-ordained. Some 60% of the funds-of-funds' gains were paid to the hedge fund managers and fund-of-fund packagers.

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As long as "nobody wants to be average," active stock picking will live on. Hope springs eternal, as The Wall Street Journal($) reports: Active Managers Stage a Comeback.

Are Actively Managed Funds Worth the Gamble?

The rise of passive investing – index funds and such – has triggered a series of Wall Street Journal articles. The rise seems unstoppable:

[F]or the last 10 years… between 71% and 93% of U.S. stock mutual funds either closed or failed to beat their closest index funds.

The Journal gives two prominent mutual fund leaders the thankless job of defending stock pickers. 

Capital Group's Tim Armour cites in-house research indicating that "active funds with low expenses and a substantial amount of the manager’s own money invested in the funds on average beat their benchmarks 89% of the time over 10-year rolling periods." 

Michael Roberge, co-CEO of MFS, refers to a study showing that bold fund managers willing and able to hold their favorite stocks for long periods do better than average. 

Both Armour and Roberge also hint that active managers may be able to limit losses by timing the market. And both point out that stock returns in the foreseeable future are expected to be below par. If so, investors who bank on index funds to provide the same growth they have enjoyed since the Great Recession will fall short of their goals. 

So why not gamble and buy active?

Long-Term Investors and Short-Haul Stocks

Some companies play for keeps. Others are in it for the short haul. One sign of short-haul companies: a fixation with increasing the market value of their shares every twelve months. One symptom of the fixation: irrational CEO compensation. One symptomatic corporation in the news lately: Valeant. 

As The New York Times observes, the fixation seems contagious:

Paying a chief executive largely or solely on the basis of stock price performance might seem reckless. It would seem to create incentives for the executive to focus on actions that get impressive results for a year or two, rather than longer-term actions that might yield higher and more sustainable profits.

But placing a heavy emphasis on the share price is a surprisingly common practice — and is supported by influential groups that advise shareholders on how to vote at annual meetings.

Index investors can't avoid short-haul companies. Selective investors can. An advantage?

Even if Active Investing Doesn't Pay, We Need It

Fewer than one of five actively managed equity mutual funds did better than comparable index funds over the past ten years. Although results over shorter periods weren't quite so bad. the majority of actively managed funds underperformed. As a result, Jason Swieg reports in the WSJ, some fund managers have thrown in the towel. They're buying a few ETFs rather than assembling portfolios of stocks.

Meanwhile, investors continue flocking to index funds.  Yet as a Cullen Roche column points out, all investors cannot do nothing but index. Active investors and active investment managers are needed to keep the market honest. See also Is Passive Investment Actively Hurting the Economy in The New Yorker. (Are index funds really responsible for the higher fees charged by large banks?)

Inexpensive online investment services based on index funds seem destined to become the basic investment platform for millennials. Even so, as their wealth grows they might enjoy setting up a side account of shares in selected companies, They'll gain the sense of being actual stockholders. And despite returns likely to be sub par, they'll be performing a public service – doing their part to keep stock prices in line with business realities.

Can Index Fund Managers Police Corporate America?

Most investors own stock indirectly. If your actively-managed fund holds GE shares, you expect the manager to vote the GE shares in the best interest of you and your fellow fundholders.

Can you have the same expectation for managers of your index funds? Should managers of S&P 500 funds, for example, become active defenders of everyday investors at all 500 companies?

Bringing these questions to mind is the news that Vanguard, BlackRock and State Street, three index-fund titans, played a major role in defending DuPont from an assault by Trian.

Maybe passive investing isn't so passive after all.

Investing in Mutual Funds Made Simple

Mutual fund investors must be bewildered by their thousands of choices, we observed recently.

Not necessarily. Mere handfuls of funds attract much of the money. "Passive" investors – that is, indexers – have an especially narrow focus. Eighty-five percent of the dollars in S&P 500 index funds reside in just five funds.

What's more, Jonathan Clements reports in the WSJ, investors in S&P 500 index funds appear to strengthen their advantage by exercising patience. As shown at right, they enjoy superior dollar-weighted  returns, presumably because they better resist the impulse to buy high, sell low.

Will robo-advisers extend the advantage of patient investing to a wider range of wealth builders?

Passive Investing vs. Pricey Investing

Vanguard Reaches $3 Trillion In Assets, Matching Entire Hedge-Fund Industry

Warren Buffett, Investment Marketer of the Year?

In his letter to shareholders last spring, Warren Buffett revealed that he had instructed his trustee to invest mostly in a very low cost S&P index fund. He recommended Vanguard's.

"in the five months that followed," the WSJ reports, "investors poured $5.5 billion into the Vanguard fund, or about three times more than during the same period the previous year."

Has indexing finally reached the tipping point and become the default way to invest?

Investing With Index Funds Sensible but Difficult

Inspired by Henry Blodget's latest warning not to play The Losers' Game, Felix Salmon praises index investing. But, he admits, the investment world doesn't make it easy to practice the discipline.

In a Bogleheads presentation last fall, John Bogle indicated that investment in indexed stock funds has grown steadily over the last two decades. Nevertheless, Most wealth in stock funds is actively managed.

If index funds represent passive investing, ETFs (to the dismay of Bogle and others) are poster children for rapid-fire trading and speculation. Still nervous from those stock market zig-zags in recent months? All those aimless gyrations surely didn't come from trading in individual stocks.

Average holding period for shares in the SPDR S&P 500, according to Bogle's presentation: 3.2 days.

Are pros with algorithms and amateurs with INDX TRADR license plates making the market too scary for ordinary investors, men and women who might otherwise be able to build enough long-term wealth to need a trust officer?

Canadian Writes Best-Selling Investment Book

O Canada, you're a nation making waves. First Adbusters, a Canadian activist group, came up with the idea to Occupy Wall Street. Now, as of November 17, Andrew Hallam, a Canadian school teacher, has the best-selling investment guide on Amazon: Millionaire Teacher, the Nine Rules of Wealth You Should Have Learned in School.

Hallam writes simply and clearly (that's not easy, folks!). Judging from a quick sampling, he does a nice job of coaxing readers to live within their means in order to put aside a little money for investment.

In the U.S., Hallam notes, as of 2009 most homes valued at a million dollars or more were not owned by millionaires. "The majority of million-dollar homes were owned by non-millionaires with large mortgages and expensive tastes."

What Investors Need vs. What Investors Want

Last Friday Jim Cramer looked straight out of the telly screen and told me to read John Bogle's column in The Wall Street Journal. O.K.

A decade ago, Bogle notes, equity index funds represented only about 5% of the market value in the equity mutual fund universe. Now it's 17%. But the market share of conventional index funds, such as the Vanguard 500 Index Fund, has flattened off at about 10%. The new growth is coming from exchange-traded funds (ETFs).

ETFs such as "spiders" are a perfectly acceptable substitute for conventional index funds as long-term holdings, Bogle concedes. Trouble is, most ETFs focus on narrow market segments. (Would you believe a "HealthShares Emerging Cancer" ETF?) And speculators are trading them like mad.

The resulting commission costs and taxes, not to mention the inevitable poor timing, lead to inferior returns for the great majority of ETF traders.

Bogle hopes serious investors eventually will realize this is no way to make money. On the other hand, there's human nature to contend with:

Surely the amazing growth of ETFs says something about the focus of money managers on gathering assets, the marketing power of brokerage firms, the activities of financial advisers, the energy of Wall Street's financial entrepreneurs, and the willingness -- nay, eagerness -- of investors to favor complexity over simplicity, continuing to believe, against all odds, that they can beat the market.

What investors need to prosper is not, alas, necessarily what they want. You can see this conflict embodied in Jim Cramer himself, says Henry Blodget in this Slate column.

The Good Cramer, the Harvard Law grad who writes astute columns and apparently did OK running a hedge fund, is an adviser any long-term investor might want to seek out. But the Bad Cramer, the clowning TV showman who blends hot tips with sound effects, is the one that draws multitudes of viewers. To Blodget, the clash between needs and wants is clear:

The two Cramers—brilliant James J. and vaudeville comic Jim—embody the essential conflict in the American financial industry:the war between intelligent investing (patient, scientific, boring) and successful investment media (frenetic, personality-driven, entertaining).

Basically, that leaves us with two questions to ponder:

How do you give investors what they need without looking like such a do-nothing dullard that you lose their business?

How do you give investors what they want without doing irreparable damage to their financial health?

Do we hear any answers?