The following is a guest post by my friend and colleague Mike from the Oblivious Investor.
Mike is a staunch advocate of passive investing in index funds. In response to my article last week, “ETF Investments,” 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 and use the buy and hold approach, 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 is 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 strategies: 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.
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 ETFs 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)?
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.
Neal’s response: I am suggesting that using a strategy that looks at short-term performance (one year, nine months, six months, three months and one 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.