Why I Only Buy Index Funds
By admin on Sep 28, 2009 in Financial Serentity
The following is a guest post by my friend and colleague Mike from the Oblivious Investor.
Mike is a staunch advocate of passive investing and index funds. In response to my article last week, “Why I don’t buy index funds now” Mike has been kind enough to make an opposing argument. Once you read Mike’s post, make sure to visit his blog and sign up for free updates.
Knowing that I’m a big fan of investing in index funds, Neal invited me to write a counterpoint to his recent series in which he explained why he doesn’t use index funds or ETFs.
For a brief reminder: Neal’s series argued that
- If you don’t want to watch your portfolio all the time, you should invest via index funds, but
- If you do want to take the time to actively manage your portfolio, you can improve your return by moving between actively managed mutual funds that will beat the market over short periods.
I agree completely with his first point. If you’re looking for funds to simply buy and hold for several years, index funds are absolutely your best bet due to their low costs and tax efficiency. Not only does this make sense theoretically, but historical data bears it out.
I am not, however, convinced about his second point.
Predicting Short-Term Performance
Neal writes, “if the performance of the actively managed funds are far better than the ETF in the short-term, you should buy the more expensive actively managed funds.
OK Neal. But to do that, you have to figure out (ahead of time) which active funds will outperform over the short-term. As far as I can tell, that means using one of two groups of strategies:
- Market timing: Determining an asset class (stocks from a given country, for instance) that will outperform over the short-term and investing in a fund that invests in that asset class, or
- Manager picking: Finding a fund manager whose above-average stock picking skills will allow him to outperform over the short-term.
Market Timing
If, for some reason, you’re confident that a particular asset class is going to earn high returns in the near future, it makes sense to invest in a fund in that asset class. But how should you go about choosing among funds in that asset class?
Neal writes that, “since you are making investment decisions based on short-term performance, it just doesn’t matter if you use ETF’s or actively managed funds.” I disagree pretty strongly with that assessment.
In fact, studies have shown that within groups of funds that have similar asset allocations, expense ratios are the single best predictor of fund performance. So why not maximize the probability of good results by investing in the least expensive funds (i.e. index funds and ETFs)?
Manager Picking
As to the strategy of picking managers who will outperform over short periods due to stock picking skill, I just can’t see why there’s any hope for this to work consistently. If it were easy to find funds run by managers with superior skill, then even for long-term buy and hold (i.e., passive) investors, it would make sense to find such a fund and dollar-cost-average into it forever.
But it’s not easy. It’s really super duper hard. And both Neal and I agree that the likelihood of success is lower than 50%. (And this is precisely why passive investors should use index funds.)
So if it’s hard to pick funds that will outperform over the long-run, why would it be any easier to pick funds that will outperform over short periods? After all, when it comes to the stock market, randomness has even more of an impact over short periods than it does over long periods.
My Suggestion: Index Funds for Everyone.
The way I see it, actively managed funds are a poor choice regardless of your investment objectives. Their fees are simply not justified by their performance. Even if you hope to outperform the market, actively managed funds are not the way to do it.
About the Author: Mike Piper is the author of Investing Made Simple. He also blogs at The Oblivious Investor.
Neal’s response: I am suggesting that using a strategy that looks at short-term performance (1 year, 9 months, 6 months, 3 months & 1 month) can indicate which areas are strongest right now. I further argue that funds that are strong right now have some short-term continuity. Studies bear this out. And the results of doing that are pretty strong. Of course, it’s not a guarantee of the future nor is it an indication that it will work every single time. In fact, as Mike points out, the outperformance of this strategy only shows up (historically) less than 50% of the time. Having said that, when it does show up, that outperformance has been very strong. This indicates:
1. Market timing is not predictive but simply an effort to capture current trends. There have been numerous studies to indicate that short-term trends have some continuity.
2. Market timing is a long-term strategy. You must be willing to stick it out and stomach the mistakes in order to take advantage of the opportunities as they present themselves.
Sorry Mike, I’m not convinced. I guess we’ll have to agree to disagree on this one.
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15 Comment(s)
By Mike Piper on Sep 28, 2009 | Reply
Neal, two questions regarding your response:
First: What reason is there to think that fund managers will exhibit above-average returns simply because they’ve done so over the very recent past?
Is there any fundamental reason you can provide for this phenomenon? I’m reluctant to place much faith in past performance figures. With the benefit of hindsight, it’s easy to come up with strategies that have beaten the market–even ones that are clearly nonsense.
Second question, simply because I’m curious: Would you (or do you) engage in such a strategy with clients’ money?
[Reply]
By MoneyEnergy on Sep 28, 2009 | Reply
Well, you guys know my response. Although I do invest in some low-cost ETFs (and will continue to do so), I see some individual stocks as common ground between these two approaches.
It’s a bit contrarian, perhaps, but this is the way I see it. If you find a good quality company with a rising history of dividends as well as its own growth potential and dominant market share in an asset class that is somewhat recession-proof AND this company has a no-fee DRIP plan…
then you can (1) invest for no costs at all; and (2) you can still set up an autopay plan so you can dollar cost average and “not think” or research your investment on an insanely regular basis. So you get the “passiveness” of the index ETF as well as an even lower cost. And, you might even increase your returns, too, since none of your money is going towards fees.
Don’t get me wrong, I’m not a 100% die-hard DRIP proponent. There are cases where it doesn’t fit. And I own tons of stocks outside of DRIPs, too. Just raising this as one small example that could be a “middle of the road” case.
Aside from that, though, I’d much rather be in a very low-cost ETF than in an actively managed fund. I’ve seen what active management has done to my precious metals and emerging market funds, which haven’t kept up at all in the recent rallies.
[Reply]
By MoneyEnergy on Sep 28, 2009 | Reply
Oh, and to agree with one of Neal’s points: as a buy-and-hold investor, I do engage in some market timing: the time when I buy the stocks. I do believe that in following market trends you can more or less identify a *better* time in which to buy your investment than some other time.
That doesn’t mean you can get in at the best time, just that it is possible to find a *better* time to buy in.
[Reply]
By Retirement Savior on Sep 28, 2009 | Reply
First off, I think index funds are possibly the most utilitarian financial products introduced in the last 30 years.
While I think market timing is difficult, there are ways to outperform that even the originators of the efficient market theory agree with, such as value and momentum.
I believe that Fama, French, Ibbotson etc., who proclaim indexing and efficient markets and show momentum as an outperformance anomaly, would not consider momentum to be market timing. I may be wrong about this, however.
By the way, Ibbotson even is part of a mutual fund company that sells value index funds (DFA).
[Reply]
By Max on Sep 28, 2009 | Reply
“First: What reason is there to think that fund managers will exhibit above-average returns simply because they’ve done so over the very recent past?”
Because of style momentum. It’s not because of manager skill, but because the manager (by chance) picked the style which has momentum.
Momentum is the flip side of value (or contrarian) investing. Value investors bet that investments that did poorly over the last several years will do well in the future. Momentum investors bet that investments that did well in the recent past will continue to do well.
[Reply]
By Neal on Sep 29, 2009 | Reply
Great response ME.
There are certainly many ways to approach investing.
[Reply]
By Neal on Sep 29, 2009 | Reply
Money Energy,
I certainly agree. I do think it’s really important to use objective data and a system that has a proven track record to do this however.
Do you use a systematic approach?
[Reply]
By Neal on Sep 29, 2009 | Reply
Not sure how Ibbotson views momentum investing, but I do seem to recall his statement that “buy and hold” may not be the way to go. I could be wrong but I think he was re-thinking his entire approach not long ago. Thanks Retirement Savior
[Reply]
By Neal on Sep 29, 2009 | Reply
Max – you said it much better than I could. I think this is the perfect response to Mike.
Also, the evidence supports the premise – as I point out in the post.
[Reply]
By Neal on Sep 29, 2009 | Reply
Mike, sorry for the delayed response and thanks again for a great post. Here you go:
As Max pointed out, because they happen to have found the correct mix. It’s not manager dependent. The link I provided shows one approach that does this successfully – though not perfectly.
Because the SEC is really picky about what an RIA writes regarding performance, I have to be really careful here. Forgive me for being vague but I can tell you that I do not manage client assets using “buy and hold”. I would be happy to go into more detail privately if you would like.
[Reply]
By Mike Piper on Sep 29, 2009 | Reply
“Momentum investors bet that investments that did well in the recent past will continue to do well.”
Right, so that’s the bet. But my question is why would you make that bet? What’s the reason other than past performance?
Also, do you choose funds that have outperformed over the last 3 months? 6 months? 12 months?
And how long do you bet on their continued outperformance?
And why would you choose those specific periods? Again, is there any reason other than data that “that’s what’s worked in the past” ?
[Reply]
By Neal on Sep 29, 2009 | Reply
Mike,
I’m going to send you my book. It goes into this subject in great detail.
I look at a blended performance which is proprietary and I review it on a periodic basis which is also proprietary. I don’t bet on continued performance – I track it and update my holdings on a fixed schedule based on the current rankings.
I’m not able to discuss performance even in general terms on this blog….I’m not trying to sell my services here and don’t want to misunderstood.
Hope that helps friend.
[Reply]
By Mike Piper on Sep 29, 2009 | Reply
Sounds like a plan. Sorry to put you in a sticky situation regarding regulations and whatnot.
And thanks again for letting me write a guest post.
[Reply]
By Neal on Sep 29, 2009 | Reply
Thanks Mike.
It’s such a pleasure to have a civil disagreement…..now if only the politicians could do that…maybe we’d get somewhere.
Great post. Thanks again!
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By Max on Sep 29, 2009 | Reply
“Right, so that’s the bet. But my question is why would you make that bet? What’s the reason other than past performance?”
The evidence is strong that momentum is a “real” market effect. It has been found in stocks, bonds, currencies, commodities, etc…every place people have looked.
Of course, the more popular momentum stratgies become, the less well they will work. So it’s realistic to expect lower returns from momentum in the future than in the past.
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