A weak case against indexing?

[McK310]

I'm a new investor at 28 years old. I began investing in a ROTH in April of 2011 and was lucky enough to stumble upon the Bogleheads forum and its invaluable wiki before committing any of my money to the market.

Even though I believe in 95% of the Boglehead approach to investing I don't want to become indoctrinated to an unhealthy extent. I've tried to search the web for cases against indexing over active management and other methods of investing and I really have not been able to find many convincing arguments or research.

I understand that for wealthy investors and those truly predisposed to making investing a lifestyle or profession there are options better suited to them such as individual stocks and bonds, hedge funds, and all that leveraging, short selling, futures, options, and other stuff I won't pretend to understand at this time.

In any case, I don't really know what to make of the point being made in this article. It seems like a reasonable point to make, but I just don't know how valid it is. I was hoping some of the more experienced and knowledgeable investors could chime in.

Also, I'd appreciate any good opinions, articles, research, etc.. which go against the basic tenets of indexing and the Boglehead way.

http://articles.businessinsider.com/201 ... -index-s-p

[lloydbraun]

I'm not going to respond in a detailed way to the article, except to say that the author of the piece did not even mention transaction costs related to portfolio turnover, which acts as a major drag on active investing. I've searched the web and every journal available through my university's databases (JSTOR, E-Journal finder, etc..) and about 95% of what I've found is favorable to indexing. In fact, in peer reviewed journals I would say that 99% of what I've read is favorable to index funds. Sorry this doesn't answer your question, but there really isn't a good case against indexing when you include transaction costs, expense ratios, and tax liability. That being said, indexing is not necessarily totally passive as fund managers tend to pick and choose which stocks will be part of their indexes, which is why they tend to say things like "80% of this fund is invested in the S&P 500". I think this is more problematic in bond funds, but there are definitely some index funds that are better than others, even when attempting to mirror the same index.

[Call_Me_Op]

Mck,

I didn't see any facts there that indicate that indexing is a bad idea. Did you?

[IlikeJackB]

Here's a quote from the end of the article:

" So, no- investing in index funds is NOT a low cost strategy. Stop making Bogle and other Bogleheads rich and start using your brain. Stay tuned to Insider Monkey for our take on several stock market anomalies that lead to much higher returns than index funds."

That monkey has nothing to offer.

[pkcrafter]

It's good that you are asking the questions and doing the research because it's important to understand and appreciate why a given investment strategy works or does not work.

Here's an earlier discussion on this topic.

http://www.bogleheads.org/forum/viewtopic.php?t=71979

Front-running was an issue, especially with the R2000, but not any longer. The article's conclusion that indexing really isn't low cost is absurdly incorrect.

Paul

[McK310]

lloydbraun,

Pretty much what I expected to hear. Thank you for the confirmation, and you're right, some index funds are definitely better than others that track the same index.

Call_Me_Op,

No, no, not at all. I am well aware of how great the Boglehead investing principles are. I just want to see what opposing information is out there. If anything, seeing that there is so little will only strengthen my confidence in the investing principles I am choosing to follow. After all, I'll be following them for my entire life so I figure it's worth some extra investigation from the get go.

Edit: This updated version of your original post is a little nicer, haha. I wasn't insulted but it was a bit aggressive. That's ok though, I'm a newb investor, I'm sure I'll say plenty of dumb (or uninformed) things on this forum.

IlikeJackB,

I didn't think so, key word -Think. Only reason I posted. I like to hear what others have to say

[kenyan]

Let's pretend for a moment that these market impact costs exist just as the author says. Now, let's pretend that the bottom 50 companies of the S&P 500 are churned each year (it's not really that high). I don't have the numbers in front of me, but I'd bet that the bottom 50 companies in the S&P 500 represent probably 2-3% of the market capitalization of the entire index. Now, let's pretend that there is a 10% bump in every single one of those companies due to the index inclusion, which is subsequently lost.

This would cause your dumb index portfolio to lose 0.2-0.3% per year due to index inclusion impact, and I used some pretty wacky assumptions.

Furthermore, if you compare a Total Stock Market fund to S&P 500, you would see significant outperformance, as the lower end of TSM involves small fractions of a percent of the index. However, there is little difference in reality, and what difference you see is largely explained by the difference in performance of small cap stocks.

Also, the fact that a stock gets added to an index does not mean that index funds immediately go out and buy that stock (or that they immediately drop it when it leaves the index). Heck, I just looked up the Vanguard 500 fund, and it contains 504 stocks. Oops. The index funds seek to track the performance of the index; that doesn't mean they do everything exactly as the index does.

[NYBoglehead]

A lot of people claim that active management beats indexing. As you are well aware, as an investment universe, the best we can we all do collectively is average, BEFORE fees. Some active funds will outperform the index, but net of fees, the INVESTORS will underperform. The ones that do outperform rarely do so on a sustained basis. In terms of fees, I look at the glaring evidence in front of my eyes. Vanguard is HQ'd in Valley Forge, PA. JP Morgan, Goldman Sachs, and Citigroup do not pay for prime Manhattan Real Estate with fancy furniture and artwork, those who invest with them and fork over incredibly high fees pay for those items.

[Taylor Larimore]

McK:

Read this article by Nobel Laureate, William Sharpe. It should remove any doubt about the advantage of indexing vs. active management:

The Arithmetic of Active Management

Best wishes.
Taylor

[Majormajor78]

Front running is an issue but not as big a one as the author makes out. Recently Vanguard has announced that it will switch indexes to the CRSP indexes which are supposed to help reduce front running since they attempt to smooth migration into and out of the index and keep the exact date that data is pulled to reconstitute the index a secret.

http://www.crsp.com/indexes/making-of-indexes.html

Here's another recent thread where somebody asked for academic literature against the Boglehead philosophy:

viewtopic.php?f=10&t=105669

Edit: added a link to CRSP website

[Noobvestor]

Here's a quote from the end of the article:

" So, no- investing in index funds is NOT a low cost strategy. Stop making Bogle and other Bogleheads rich and start using your brain. Stay tuned to Insider Monkey for our take on several stock market anomalies that lead to much higher returns than index funds."

That monkey has nothing to offer.

Lulz ... Bogleheads is a non-profit, and Bogle is so rich he really does not need any more money, yet he continues to write books and help investors out of kindness and compassion. So sad.

[BHCadet]

Here's a quote from the end of the article:

" So, no- investing in index funds is NOT a low cost strategy. Stop making Bogle and other Bogleheads rich and start using your brain. Stay tuned to Insider Monkey for our take on several stock market anomalies that lead to much higher returns than index funds."

That monkey has nothing to offer.

Lulz ... Bogleheads is a non-profit, and Bogle is so rich he really does not need any more money, yet he continues to write books and help investors out of kindness and compassion. So sad.

The article has admitted. Bogleheads investment philosophy is making us getting rich.

[bottlecap]

Even with frontrunning, indexing wins. If indexes didnt drop stocks, it would change the risk profile of the index. The author isn't comparing apples to apples.

JT

[RyeWhiskey]

McK:

Read this article by Nobel Laureate, William Sharpe. It should remove any doubt about the advantage of indexing vs. active management:

The Arithmetic of Active Management

Best wishes.
Taylor

Fantastic article. Thank you for posting that Taylor, it sums up in exactly the right terms (i.e. absurd simplicity) what it is we are talking about.

[mlewis]

When I first started reading about index investing I also wanted to be prudent and look for the counter arguments.
Web searches would occasionally turn up things such as articles that Rick Ferri or Paul Merriman would write, refuting the common claims that active management style advisors tell their clients about why passive investing is inferior.

As far as any real evidence against indexing- I never found any.


Many wealthy investors just dont know that indexing is better. They are pretty satisfied with the idea that they are smart and hire the best in the business. Unfortunately for them, they are the cash cows of the industry, and the reason pros on wall street make the big bucks.

Sit back and enjoy the free ride- they are all paying the wall st. pros to go around and price the securities for us, so that indexing actually works.

malcolm

[market timer]

One could use Total Stock Market Index and avoid the criticism of this article.

[EyeYield]

Indexing is simple and boring, so you can't really sell a lot of advertising with stories and programs about it. Monkeys hate it because it screws up their dart game.

Of course you'll never hit that home run with Indexing. You know, the one everybody has dreamed about at one time or another,"I bought it at $2.00 and it went to $200 in 12 months". (Well, did you sell it?) A large majority of people trying to hit that home run strike out, but the few that do make the most noise - for a while.
Also, the people who hit the home runs either know what nobody else knows or are lucky - at least once.

It's fun to dream (and gamble) and I've noticed that many Bogleheads have a 1-5% fantasy allocation - nothing wrong with that.

[McK310]

Thank you for all the responses and great links. I will definitely read the articles and threads in the next few days.

I feel pretty fortunate to have discovered indexing from the start. I find it amazing that only something like 15-25% of all investor assets are invested in index funds. I think it's terrible that so many people are steered towards higher cost investment vehicles, which promise higher returns. I guess "the wall street machine" coupled with investor greed and ignorance is enough to ensnare those who don't know any better.

It just makes me wonder, is it really this simple? All I have to do is set a reasonable AA, readjust it accordingly with age, choose 3-6 well diversified funds, and then just follow the priorities of investing in 401(k) match, max the ira, max the 401(k), contribute to any HSA's, then toss the remainder into a taxable account following all the tax-efficient fund placement rules? And this will not only save me from hindering my own potential returns but also hours of research and deliberation?

I suppose it just seems too good to be true. I mean there are so many complicated investment strategies listed on investopedia it's mind boggling, ( no pun intended, ha) and they all seem so mmmm, i don't know what word to use - professional? complex? risky?, forex trading, derivatives, straddling, and a hundred others I don't think I'll ever care to really learn about.

Maybe indexing is just best for the lazy or uninformed investor, or the investor with only modest capital (aka the un-wealthy)? Surely it can't be this simple. Surely there must be ways for intelligent, educated, committed people (even if it has to be teams of them) to capture returns above the the long term 9.5% of the S&P 500. But, I could be wrong. The more I learn the more it appears that I am. It's just strange is all.

[grabiner]

It just makes me wonder, is it really this simple? All I have to do is set a reasonable AA, readjust it accordingly with age, choose 3-6 well diversified funds, and then just follow the priorities of investing in 401(k) match, max the ira, max the 401(k), contribute to any HSA's, then toss the remainder into a taxable account following all the tax-efficient fund placement rules? And this will not only save me from hindering my own potential returns but also hours of research and deliberation?

Max the HSAs before making unmatched contributions to the IRA or 401(k), but otherwise, this is right.

What you will get out of this is a before-expense return of the average return of all investors with the same allocation (if you use index funds) or close to that (if you have a well-diversified portfolio using active funds). And if you use low-cost funds, and stock index funds in your taxable account, your after-expense return will be very close to the before-expense return.

If you don't follow this strategy, you are almost certainly going to wind up with higher costs, paid to fund managers, brokers, and the IRS. You may come out ahead or behind before costs, but the costs mean that you should expect to come out behind in the long run. I would prefer to reliably underperform the market by 0.3% (about what I lose to taxes and costs in my portfolio) than to be equally likely to beat it by 3% or lose by 5% (with a more active portfolio).

Surely there must be ways for intelligent, educated, committed people (even if it has to be teams of them) to capture returns above the the long term 9.5% of the S&P 500. But, I could be wrong.

The reason that it doesn't work is that there are so many teams of intelligent, educated, and committed people, who manage mutual funds, pensions, endowments, and hedge funds, and their joint efforts determine the prices. The average large-cap fund manager matches the S&P 500 before expenses, but because the manager has to get paid, the investor in this fund expect to underperform. (This is even true for index funds; it costs 0.05% annually to run Vanguard's S&P 500 index fund, and the fund can't make that up.)

[mlewis]

Max the HSAs before making unmatched contributions to the IRA or 401(k), but otherwise, this is right.

could you explain why you favor the HSA before IRA?
An IRA would have better options/lower fees typically.

[Call_Me_Op]

I feel pretty fortunate to have discovered indexing from the start. I find it amazing that only something like 15-25% of all investor assets are invested in index funds. I think it's terrible that so many people are steered towards higher cost investment vehicles, which promise higher returns. I guess "the wall street machine" coupled with investor greed and ignorance is enough to ensnare those who don't know any better.

Keep in mind that the investment industry has a vested interest in having investors believe that active management is the way to go - that's how they generate their enormous profits. Since nobody likes to be average, they can exploit this fact. But the truth is the with investing, average is well above the average.

P.S. I see you caught me in my frenzy (multiple iterations) to update my earlier post in order to tone-down my response. It can sometimes be frustrating, because this is really just mathematics. Active managers are the market, so when one wins another must lose. Their net activity averages to zero with respect to the market BEFORE costs. After costs, they must on average lag the market. When you add in the fact that there is no persistence in manager relative performance - that is, you cannot predict who will be the winners - you realize that active management is statistically a losers game (and that must be so).

[bottlecap]

Maybe indexing is just best for the lazy or uninformed investor, or the investor with only modest capital (aka the un-wealthy)? Surely it can't be this simple. Surely there must be ways for intelligent, educated, committed people (even if it has to be teams of them) to capture returns above the the long term 9.5% of the S&P 500. But, I could be wrong. The more I learn the more it appears that I am. It's just strange is all.

Teams of smart people are pitted against other teams of smart people coming to different conclusuions. Smart people must be paid a lot of money. Buying and selling to implement strategies costs money. These facts result in their failure to beat the indexes after costs. It is not to good to be true - it is simple. Thinking your team of smart people can consistently out-guess all the other teams of smart people is too good to be true. If that were the case, the rest of the smart people would be out of jobs as a result of their consistent failure.

JT

[nisiprius]

McK310, one issue is this. There might be a weak case of indexing, but site named InsiderMonkey is not the place to find it. Your BS detectors should have been pinging left, right, and center at this article. It is pure propaganda, without any leavening of information.

For example, by choosing to attack the S&P 500 indexes and the Russell 2000 index, it is setting up a straw man. It is like attacking aviation by saying "It's not as safe as you think it is! Look at the Hindenburg!" The issues with the S&P 500 and the Russell 2000 are well-known. If this were an honest exploration, he would compare and contrast the issues with these old indexes and the modern ones which are designed specifically to avoid issues with front-running and index recomposition. He doesn't talk about this. He doesn't know. He doesn't care. He's not trying to learn or teach anything, he's just picking up an old time-tested stick with which to beat index funds.

But the article is poisoned at his source. "InsiderMonkey?" Give me a break. I have no problem at all with "monkey," but I have a huge problem with the word "[b]Insider," [/b]even if it's not to be taken seriously.

See, there is, absolutely, a way to beat the index and, indeed make a killing, and that is to have inside information and trade on it without getting caught. All along, one dark side of retail investing has been the nudge-nudge-wink-wink appeal by con artists to marks. Con artists who are not insiders, but who want marks to believe that they are.

In the 1920s and before modern regulation, a "bull" did not mean an investor who expected the stock market to go up, it mean someone who was trying to make the market go up. Manipulation was assumed. In Frank Norris' fictional "The Pit," we read an imaginary news item

"an Unknown Bull has invaded the Chicago wheat market since the beginning of the month, and is now dominating the entire situation. The Bears profess to have no fear of this mysterious enemy, but it is a matter of fact that a multitude of shorts were driven ignominiously to cover on Tuesday last, when the Great Bull gathered in a long line of two million bushels in a single half hour... The new operator's identity has been carefully concealed... It has been rumoured that he hails from New York,

So there was, and probably still is, real inside information, and illegal but valid "stock tips" that are worth fortunes, and real "insiders" who can deliver them. The victim's dream is to find entry into this circle. For every real insider, there are a hundred con artists whose game is to convince the victims that they are just such a point of entry.

Many of Madoff's victims believed that they were the beneficiaries of illegal maneuvers on the part of his firm--that due to his NASDAQ connections his firm was front-running trades. It would be wonderful to have recordings of the actual conservations from which they gleaned this impression.

This strain plays, with varying intensities, throughout the retail industry. Consider the classic E. F. Hutton TV commercials, which many still remember. YouTube has some. A guy says "My broker is E. F. Hutton, and E. F. Hutton says..." and there is dead silence as everyone in the vicinity stops to catch the information.

What, exactly, do you think this is about? In this case, I perceive it to be half-joking. The 1970s were not the 1920s and I hope that nobody really believed that E. F. Hutton's clients get to talk to Mr. E. F. Hutton personally, nor that Mr. E. F. Hutton knows who the Unknown Bull is or what market-roiling maneuver he is about to make. But the message is still: "inside information." Hutton's marketers would surely have said they didn't really mean inside information. They meant only information that goes right up to the line separating legal information from illegal inside information, information obtained through E. F. Hutton's army of analysts with their superior and penetrating insight, information giving Hutton's clients an unfair but perfectly legal advantage.

I am sure that InsiderMonkey would say that "insider" is just a lighthearted word not intended to be taken seriously. But the urge to be connected with insiders is a real danger to investors--not a danger of underperforming, losing half a percent to advisory fees or expense ratios. It's the danger of being caught up in a scam. One of the self-protective things one should do is to resist anything that smacks of invitation to an inner circle.

In your case, the idea of not letting yourself be utterly captured by the clubby atmosphere of Bogleheads, which does have some "groupthink," is a good idea. But going to a place that calls itself "InsiderMonkey" for responsible presentation of opposing views is not.

[leonard]

I understand that for wealthy investors and those truly predisposed to making investing a lifestyle or profession there are options better suited to them such as individual stocks and bonds, hedge funds, and all that leveraging, short selling, futures, options, and other stuff I won't pretend to understand at this time.

Why precisely do you "understand" this? Very few people - wealthy or not - consistently outperform the market on a risk adjusted basis.

[Akiva]

Despite what a bunch of academics with flawed statistical studies say, skilled professionals can "beat" passive index investing for a variety of reasons. But you are not a skilled professional and you have no way to figure out if the person claiming to be one actually is one or is just selling snake oil. (And unless you have a whole lot of money, such a person really has no incentive to let you invest with them in the first place. And if you *did* have a whole lot of money, the snake oil salesmen would have even more of an incentive to dupe you.)

Furthermore, every year, Dalbar releases a report that compares investor returns with index returns. For the 20-year period ending in Dec 2011, equity investors earned an averaged annual compounded return of 3.49%. Over the same period, the S&P500 index returned 7.81%. Thus, people's bad investing habits cost them 4.32% per year. This is low hanging fruit. By following sound investing advice available here and elsewhere, you can get returns very close to that of the index. Simply being minimally competent lets you do better than 90-95% of investors out there for very little work -- a pretty good trade-off, and one that you should be happy with seeing as you aren't doing this as your profession.

[Call_Me_Op]

Despite what a bunch of academics with flawed statistical studies say, skilled professionals can "beat" passive index investing for a variety of reasons.

...the main one being luck.

[lloydbraun]

I don't think that academics have done flawed statistical studies as they are just observing active mutual fund managers. Are the sIkilled professionals you're talking about mutual fund managers or hedge fund managers?

[Akiva]

Despite what a bunch of academics with flawed statistical studies say, skilled professionals can "beat" passive index investing for a variety of reasons.

...the main one being luck.

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

I don't think that academics have done flawed statistical studies as they are just observing active mutual fund managers.

Sadly, there's a lot more bad research and flawed statistics than there is good, reliable work.

Are the sIkilled professionals you're talking about mutual fund managers or hedge fund managers?

Because of the way mutual funds are structured it is basically impossible for an actively managed fund to beat the market on any consistent basis. (And it isn't for the reasons that Sharpe points out in his paper. It's just a consequence of the portfolio mathematics; you can make absurdly optimistic assumptions about a manager's forecasting ability and he still will have trouble beating the market by enough to cover his fees.)

Hedge fund fund-of-funds beat the market in a technical sense (more below), but actually investing in these funds requires some acumen and financial knowledge because you need to understand how the various strategies work together as a portfolio. Furthermore, it's highly likely that the superior risk adjusted returns of hedge funds-of-funds is an artifact of relatively few people using them historically. As more investors use them, their risk-reward trade-off should fall into line with that of other investments.

What I had in mind is this -- if you think of the financial markets as being like a game of poker between the active traders, then it isn't that half the managers come out ahead and half come out behind, it's that the mistakes of the bottom 80% create return opportunities for the top 20% (who are professionals, insiders, etc. -- i.e. people who don't offer investable funds or who do so only for select individuals). So, e.g., Goldman's energy derivatives desk will beat the energy market pretty much every year; their fixed income desk will beat the fixed income market. etc. If this wasn't true, then they wouldn't be in business and markets would have no liquidity.

Going back to the fund-of-funds thing (almost no one should invest in individual hedge funds), between Dec-89 and Jan-11, the S&P returned 8.2% with a standard deviation of over 15%, the HFR fund of funds index (sadly not investable) returned 7.4%, but did it with a standard deviation of under 6%, i.e., it had more than double the sharpe ratio, thus "beating" the market. (Over that time period the S&P had a 51% decline between Nov-07 and Feb-09 and a 45% decline between Sept-00 and Sept-02. The HFR index had only 1 large loss, a 22% decline from Nov-07 to Feb-09. So contrary to popular opinion, hedge funds are relatively safe, conservative investments which is why institutional investors like them.)

Also, it's worth noting that just like I said above with the stock market, most hedge fund investors did not see returns this good because they did all the same stupid stuff that people who invest in active mutual funds do. If you were going to invest in this sector, trying to build a portfolio of fund-of-funds that gives index-like returns would be the way to go. (But that's not what most people do.)

[Call_Me_Op]

Despite what a bunch of academics with flawed statistical studies say, skilled professionals can "beat" passive index investing for a variety of reasons.

...the main one being luck.

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

Sounds like insider trading to me.

[Akiva]

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

Sounds like insider trading to me.

The major banks and other market participants have significant institutional advantages that have nothing to do with insider information. Look there are proprietary trading firms (i.e. private companies that do nothing but trade the markets) like Jane Street that show profits day-in and day-out. But normal investors will never be able to achieve these sorts of returns.

[Call_Me_Op]

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

Sounds like insider trading to me.

The major banks and other market participants have significant institutional advantages that have nothing to do with insider information. Look there are proprietary trading firms (i.e. private companies that do nothing but trade the markets) like Jane Street that show profits day-in and day-out. But normal investors will never be able to achieve these sorts of returns.

If normal investors do not have access (to whatever it is you are referring to) it is not really relevant to this discussion. We are discussing investment options from the OP's perspective.

[Akiva]

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

Sounds like insider trading to me.

The major banks and other market participants have significant institutional advantages that have nothing to do with insider information. Look there are proprietary trading firms (i.e. private companies that do nothing but trade the markets) like Jane Street that show profits day-in and day-out. But normal investors will never be able to achieve these sorts of returns.

If normal investors do not have access (to whatever it is you are referring to) it is not really relevant to this discussion. We are discussing investment options from the OP's perspective.

It was relevant to the point I was making -- that while professionals can "beat the market", they do that because they are professionals; there is no reason to think that an ordinary investor will be able to capture this. So you are better off keeping it simple and indexing to beat 90% of the world than doing all kinds of complicated stuff in a futile attempt to be in the top 1% of performers.

[McK310]

Keep in mind that the investment industry has a vested interest in having investors believe that active management is the way to go - that's how they generate their enormous profits. Since nobody likes to be average, they can exploit this fact. But the truth is the with investing, average is well above the average.

This is exactly why I think it's terrible that the financial industry does this. They are suppose to be professionals and experts. I don't mind if they profit reasonably in proportion to the service they are providing to their customers, the advice they give them, and the value they add to their portfolio but I think its pretty reprehensible that financial professionals would use their expertise to exploit the average person who is trying to build a nest egg for themselves and their family. What happened to the whole concept of fiduciaries and trustees? Shameless greed.

There might be a weak case of indexing, but site named InsiderMonkey is not the place to find it. Your BS detectors should have been pinging left, right, and center at this article. It is pure propaganda, without any leavening of information.

I know its just an article on businessinsider.com and of course I was skeptical of the information in it. That's why I posted it here, to see how much credence, if any, it has. That's an interesting tidbit about how the term "bull" actually originated by the way.

In your case, the idea of not letting yourself be utterly captured by the clubby atmosphere of Bogleheads, which does have some "groupthink," is a good idea. But going to a place that calls itself "InsiderMonkey" for responsible presentation of opposing views is not.

I think it's a good idea too. I've gone to many other places besides InsiderMonkey. Apparently it's pretty difficult to find good information opposing indexing. If you have any more credible sources I would love to investigate them.

Why precisely do you "understand" this? Very few people - wealthy or not - consistently outperform the market on a risk adjusted basis.

Ok, ok you got me. Perhaps surmise is a better word than understand. I wish I could find it but I remember seeing an article that listed the returns, or CAGR's maybe, of some of the biggest and most well known hedge funds in the world and the numbers were way above any of the standard benchmarks. I know they charge something like a hefty 20% fee for admittance into the fund and you need a minimum of 1 million to get in, but if those numbers are true it still seems worth the price. I'll try to find it again if I can.

[Call_Me_Op]

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

Sounds like insider trading to me.

The major banks and other market participants have significant institutional advantages that have nothing to do with insider information. Look there are proprietary trading firms (i.e. private companies that do nothing but trade the markets) like Jane Street that show profits day-in and day-out. But normal investors will never be able to achieve these sorts of returns.

If normal investors do not have access (to whatever it is you are referring to) it is not really relevant to this discussion. We are discussing investment options from the OP's perspective.

It was relevant to the point I was making -- that while professionals can "beat the market", they do that because they are professionals; there is no reason to think that an ordinary investor will be able to capture this. So you are better off keeping it simple and indexing to beat 90% of the world than doing all kinds of complicated stuff in a futile attempt to be in the top 1% of performers.

I don't fully understand your case in point. If one firm has an advantage in trading any stocks (compared to the general public), that smells of insider trading. Just how do these professionals beat the market without having an unfair advantage (privy to information others do not have)?

[leonard]

Why precisely do you "understand" this? Very few people - wealthy or not - consistently outperform the market on a risk adjusted basis.

Ok, ok you got me. Perhaps surmise is a better word than understand. I wish I could find it but I remember seeing an article that listed the returns, or CAGR's maybe, of some of the biggest and most well known hedge funds in the world and the numbers were way above any of the standard benchmarks. I know they charge something like a hefty 20% fee for admittance into the fund and you need a minimum of 1 million to get in, but if those numbers are true it still seems worth the price. I'll try to find it again if I can.

I think you need to research this point further. I doubt my argument will convince you completely.

The problem with the idea that the wealthy or the smart have this additional ability I think is what temps many people away from indexing. At the very least, in encourages the attitude that "play money" in investing makes sense. The reality is that very few beat the market on a risk adjusted basis. Even fewer beat the market on a consistent basis. Hedge funds etc are marketing to attract assets. Of course they are going to quote high returns. But, the reality is that very, very few money managers beat the odds over time.

The reason is that this is important: the sooner you eliminate the sirens call that there is "something better out there" the sooner you focus on optimizing a low cost, indexed asset allocation and move on to other things. These other options for higher return are at least a distraction - if not much worse.

[EDN]

I'm a new investor at 28 years old. I began investing in a ROTH in April of 2011 and was lucky enough to stumble upon the Bogleheads forum and its invaluable wiki before committing any of my money to the market.

Even though I believe in 95% of the Boglehead approach to investing I don't want to become indoctrinated to an unhealthy extent. I've tried to search the web for cases against indexing over active management and other methods of investing and I really have not been able to find many convincing arguments or research.

I understand that for wealthy investors and those truly predisposed to making investing a lifestyle or profession there are options better suited to them such as individual stocks and bonds, hedge funds, and all that leveraging, short selling, futures, options, and other stuff I won't pretend to understand at this time.

In any case, I don't really know what to make of the point being made in this article. It seems like a reasonable point to make, but I just don't know how valid it is. I was hoping some of the more experienced and knowledgeable investors could chime in.

Also, I'd appreciate any good opinions, articles, research, etc.. which go against the basic tenets of indexing and the Boglehead way.

http://articles.businessinsider.com/201 ... -index-s-p

McK310,

I wanted to respond to this quickly while fully acknowledging I haven't read the other responses. The issues that the article brings up are well known in the investment industry, and companies like Vanguard and DFA go to great lengths to avoid the costs associated with buying and selling stocks around the time that the indexes are updated. For example, in the large growth (S&P 500) space, the two funds I use are the Vanguard 500 Signal Share and the DFA US Large Company Fund. For the last 10 years through 12/31, the S&P 500 Index (no costs) earned +7.10% per year. VIFSX earned +7.05% and DFUSX earned +7.11%. In the case of Vanguard, that return is equal to the index return minus the 0.05% expense ratio, indicating no additional costs. DFAs S&P 500 actually beat the S&P 500 net of its 0.1% expense ratio due to being a bit more flexible around buying/selling stocks during reconstitution, and probably a % or two more from securities lending. Same thing for the most part in the small cap market. This really isn't something to worry about as the S&P Index vs. Active scorecards routinely show that the vast majority of active managers underperforms their indexes despite these flaws.

Finally, this comment:

I understand that for wealthy investors and those truly predisposed to making investing a lifestyle or profession there are options better suited to them such as individual stocks and bonds, hedge funds, and all that leveraging, short selling, futures, options, and other stuff I won't pretend to understand at this time.

is not true. There is no level of wealth where the basic tenants of asset allocation, diversification, low costs, and portfolio persistence are not the dominating factors. I am one of the "professionals" you mention with the same CFA designation that the hedge fund managers have, and advise people who can be considered "wealthy", and I have invest their money 100% in index funds with absolutely no active management or market timing. I know others here with the same/similar credentials do the same thing. I have looked at our results over time compared to, for example, the $1B+ college endowments, who you would think would be able to outperform a simple mulit-asset class index fund portfolio. I have found they haven't outperformed us (adjusted for risk), nor have they outperformed basic Total Market portfolios (US Total Stock index, International Total Stock index, and Total Bond index). If they aren't doing it with their immense wealth and vast resources (save for a few like Yale or Princeton), neither are other "wealthy" investors. We're all better off indexing.

Hope this helps.

Eric

[Akiva]

I don't fully understand your case in point. If one firm has an advantage in trading any stocks (compared to the general public), that smells of insider trading. Just how do these professionals beat the market without having an unfair advantage (privy to information others do not have)?

The easiest way to explain it may be this:

The vast majority of people executing trades in the market are idiots whose trading hurts their returns. So average, "normal" people lose money when they trade. Now if you could do the exact opposite of what normal people do, you'd have an expected excess return equal to the losses that normal people incur. A normal person doesn't have the kind capital and relationship with the exchange that would let them do this. But in order for "normal" people to go out and be stupid like this, *someone* has to take the other side of their trades -- and these firms are that someone.

And for the record, the stock market is a relatively small part of the global financial market. Fixed income and forex are each about 5x larger than stocks, and derivatives are about 35x as big. So it would be a gross mischarecterization to say that these guys are just trading stocks. (The only market for which "insider trading" even makes sense.)

[Call_Me_Op]

I don't fully understand your case in point. If one firm has an advantage in trading any stocks (compared to the general public), that smells of insider trading. Just how do these professionals beat the market without having an unfair advantage (privy to information others do not have)?

The easiest way to explain it may be this:

The vast majority of people executing trades in the market are idiots whose trading hurts their returns.

This is contrary to my understanding, which is that the vast majority of trading is performed by professional money managers and institutional traders.

[Akiva]

I don't fully understand your case in point. If one firm has an advantage in trading any stocks (compared to the general public), that smells of insider trading. Just how do these professionals beat the market without having an unfair advantage (privy to information others do not have)?

The easiest way to explain it may be this:

The vast majority of people executing trades in the market are idiots whose trading hurts their returns.

This is contrary to my understanding, which is that the vast majority of trading is performed by professional money managers and institutional traders.

Just because they are institutions doesn't mean they aren't losing money when they trade. At a minimum they have to cross the bid-ask spread and deal with slippage from their large order size, all of which is profit that accrues to the people taking the other side of that trade. Furthermore, lots of the institutional traders are trading for reasons that have nothing to do with where they think the market will go. A mutual fund has high redemption and has to sell some assets to replenish it's cash reserves, an oil company has to hedge a certain % of production in order to keep a line of credit from their bank, a manufacturing company needs to move cash from one country to another and so trades in the forex market, etc.

Going back to the hedge fund example, during the 07-08 financial crisis, hedge funds had a 22% loss. Much of that was self-inflicted because institutional managers started pulling money out when things got shaky and the funds ended up having to pay a steep liquidity premium to cash out and meet their redemptions. (Had those institutional managers followed the advice here, they'd have rebalanced by moving money in from their bond allocation.) The following year was one of the largest up years for hedge funds, but all these big sophisticated institutions missed out because they pulled their money out at the bottom and didn't put it back in until *after* the funds had seen big gains.

Point being that these big players are often not trading rationally, but they still need to trade for whatever reason. Providing liquidity by taking the other sides of these trades entails risk and the liquidity providers will only take the risk if they are compensated for it.

[McK310]

The problem with the idea that the wealthy or the smart have this additional ability I think is what temps many people away from indexing. At the very least, in encourages the attitude that "play money" in investing makes sense. The reality is that very few beat the market on a risk adjusted basis. Even fewer beat the market on a consistent basis. Hedge funds etc are marketing to attract assets. Of course they are going to quote high returns. But, the reality is that very, very few money managers beat the odds over time.

The reason is that this is important: the sooner you eliminate the sirens call that there is "something better out there" the sooner you focus on optimizing a low cost, indexed asset allocation and move on to other things. These other options for higher return are at least a distraction - if not much worse.

You're right. Being that I'm new to this and admittedly don't know my *ss from my elbow I am sometimes tempted to search for greener pastures. But I'm very convinced at this point that all the fundamentals outlined in the wiki here is the best way to go, and by far. I think it's understandable enough that someone new to anything will always look for something better even when they know they've found something very good. Once they learn, read, and experience more they will usually find that most or all of those "something betters" are not what they claim or appear to be. I a merely in this stage and feel the need to exercise my curiosity before I lay it to rest and move on to other things, as you say.

Nevertheless, I appreciate all the responses in this thread thus far. I didn't think I'd get so many responses so quickly. This really is a great community.

...The issues that the article brings up are well known in the investment industry, and companies like Vanguard and DFA go to great lengths to avoid the costs associated with buying and selling stocks around the time that the indexes are updated....This really isn't something to worry about as the S&P Index vs. Active scorecards routinely show that the vast majority of active managers underperforms their indexes despite these flaws.

Thank you for the clarification. Even if there was a drag of .25, .5, or even 1% because of this all the expense and tax costs of active management over indexing would still allow indexing to come out on top by a fair margin. I think a big part of the reason it's so hard for me to fully believe that indexing is the best way to invest is because 3/4 of all other investors supposedly do not participate in it. I mean, I know the masses aren't exactly the best place to go for a frame of reference on what is wise or prudent, but really? It just baffles me that people would select more expensive, more complicated alternatives, but I suppose that is the effect of big business and the price of ignorance.

There is no level of wealth where the basic tenants of asset allocation, diversification, low costs, and portfolio persistence are not the dominating factors. I am one of the "professionals" you mention with the same CFA designation that the hedge fund managers have, and advise people who can be considered "wealthy", and I have invest their money 100% in index funds with absolutely no active management or market timing. I know others here with the same/similar credentials do the same thing. I have looked at our results over time compared to, for example, the $1B+ college endowments, who you would think would be able to outperform a simple mulit-asset class index fund portfolio. I have found they haven't outperformed us (adjusted for risk), nor have they outperformed basic Total Market portfolios (US Total Stock index, International Total Stock index, and Total Bond index). If they aren't doing it with their immense wealth and vast resources (save for a few like Yale or Princeton), neither are other "wealthy" investors. We're all better off indexing.

I believe what you're saying is true, it's just surprising. I just assumed that smart, specialized people with fancy computer programs and all sorts of other resources at their disposal had ways to beat the market and make themselves and their constituents two or three times what the average investor would expect from a strategy as simple and low-maintenance as indexing. I guess I'm just looking to find something that isn't there. Still, I'm glad I looked.

[Call_Me_Op]

I don't fully understand your case in point. If one firm has an advantage in trading any stocks (compared to the general public), that smells of insider trading. Just how do these professionals beat the market without having an unfair advantage (privy to information others do not have)?

The easiest way to explain it may be this:

The vast majority of people executing trades in the market are idiots whose trading hurts their returns.

This is contrary to my understanding, which is that the vast majority of trading is performed by professional money managers and institutional traders.

Just because they are institutions doesn't mean they aren't losing money when they trade. At a minimum they have to cross the bid-ask spread and deal with slippage from their large order size, all of which is profit that accrues to the people taking the other side of that trade. Furthermore, lots of the institutional traders are trading for reasons that have nothing to do with where they think the market will go. A mutual fund has high redemption and has to sell some assets to replenish it's cash reserves, an oil company has to hedge a certain % of production in order to keep a line of credit from their bank, a manufacturing company needs to move cash from one country to another and so trades in the forex market, etc.

Going back to the hedge fund example, during the 07-08 financial crisis, hedge funds had a 22% loss. Much of that was self-inflicted because institutional managers started pulling money out when things got shaky and the funds ended up having to pay a steep liquidity premium to cash out and meet their redemptions. (Had those institutional managers followed the advice here, they'd have rebalanced by moving money in from their bond allocation.) The following year was one of the largest up years for hedge funds, but all these big sophisticated institutions missed out because they pulled their money out at the bottom and didn't put it back in until *after* the funds had seen big gains.

Point being that these big players are often not trading rationally, but they still need to trade for whatever reason. Providing liquidity by taking the other sides of these trades entails risk and the liquidity providers will only take the risk if they are compensated for it.

I understand what you are suggesting - but I do not think this is a dominant factor. Just because a trade doesn't go well doesn't mean the person making it is "dumb." Every trade has a winner and a loser - by definition - but half of the traders are not dumb.

[telemark]

One reason people use managed funds is that index funds aren't available to them. About half my portfolio is in managed funds, because my current 401K plan only has one index fund in it. You make do with what you have.

And while you're doing your due diligence, of which I approve, try doing a web search on "closet indexers".

[BillyG]

Being wealthy entitles you to pay more for your investments, nothing more, nothing less.

But paying more for your investments does not make you wealthy.

Billy

PS Being wealthy entitles an index investor to buy Amiral shares at the getgo.

[Akiva]

I understand what you are suggesting - but I do not think this is a dominant factor. Just because a trade doesn't go well doesn't mean the person making it is "dumb." Every trade has a winner and a loser - by definition - but half of the traders are not dumb.

Most estimates that I've seen are that about 80% of people who trade lose money on their trades. Trading is a lot like a poker game in that it disproportionately rewards the very few extremely skilled people at the expense of everyone else who is "playing".

In any event the point was that this isn't directly accessible as an investment because what they are doing has more in common with insurance underwriting than with investing.

[Call_Me_Op]

Akiva,

I do not have firm data on hand at the moment, but I find it inconceivable that 20% of traders would consistently make smarter trades than everyone else. This is inconsistent with everything I have read about market participants and efficiency. If what you say is true, then there would be a case against indexing - just have one of the 20% manage your money. Or are you going to tell me that we do not have access to these masked men?

[Akiva]

Akiva,

I do not have firm data on hand at the moment, but I find it inconceivable that 20% of traders would consistently make smarter trades than everyone else. This is inconsistent with everything I have read about market participants and efficiency. If what you say is true, then there would be a case against indexing - just have one of the 20% manage your money. Or are you going to tell me that we do not have access to these masked men?

1) As I pointed out above, hedge fund fund-of-funds have beat the market on a post-fee basis historically. The same is true of CTA fund-of-funds. (The reason these people take outside money is because the fee structure gives the managers a free option on the portfolio.) If you are an accredited investor like Swensen with enough money and enough know-how to build an index-like portfolio of these funds, then a significant allocation to them would improve your overall performance if you invested responsibly. However, determining whether these outstanding risk-adjusted returns will always be there or whether they are only there right now because most accredited investors under-allocate to these funds is a difficult question.

2) However we can set all of those options aside because legally most investors on this forum can't invest with them at all and because most of the ones who could invest with them don't have the know-how to perform proper due diligence on the funds they are interested in. Furthermore these aren't the people I'm talking about.

3) The companies I'm talking about make money because they are providing liquidity to the market and taking the other side of a whole bunch of typically losing trades in the process. In the old days, these were the guys who stood in the trading pit all day and traded on their own account. Now it's all computerized and high-tech, but conceptually it's the same thing. There's nothing inconsistent with pointing out that they "beat the market" because as far as most academics are concerned, what they are doing doesn't count as investing, it's just a trading business that makes money for relatively mundane non-academically interesting reasons. (Some academics do study these guys though. There's a whole elaborate theory that uses Bayesian statistics to explain how their business activity affects the bid-ask spread, liquidity, market impact of large orders, etc.)

4) As for investing in what these guys do, in the case of the major investment banks, you actually do invest in that line of business by holding their stock. But for whatever reason, most of the companies doing this stuff are private and hence not something you can invest in. Beyond that, you wouldn't want to put *all* of your money into this business anymore than you'd want to put *all* of your money into any other specialized business.

5) Setting aside the fact that these guys don't take outside money, assuming they did, how are you going to know in advance who is legit and who isn't? Do you understand enough about the mechanics of how markets work to evaluate such an operation as an ongoing business? If you are willing to do that work here, why wouldn't you be willing to do it with stocks more generally instead of indexing?

6) If they did take your money, who says their fees won't wipe out the extraordinary gains they produce? After all, plenty of active mutual funds beat the market *before* fees. It's just that they can't beat it by enough to cover the fees they charge. Why would it even make sense for those extra returns to accrue to you? You didn't do anything to earn them; you are just providing capital. And since they can always borrow at close to the risk free rate, paying you more than that wouldn't be rational.

[KyleAAA]

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

Sounds like insider trading to me.

The major banks and other market participants have significant institutional advantages that have nothing to do with insider information. Look there are proprietary trading firms (i.e. private companies that do nothing but trade the markets) like Jane Street that show profits day-in and day-out. But normal investors will never be able to achieve these sorts of returns.

That's comparing apples to oranges, though. You can't take a proprietary trading desk doing, say, interest rate arbitrage, etc and say the "beat the market." What market? The stock indices? That's a faulty comparison. Besides, those trading desks operate with a lot more leverage than retail investors do, and they have a tendency to make a lot of money until they blow up spectacularly. They didn't beat the market. They aren't even playing in the same market. Ditto for hedge funds. That would be like saying you beat the market by investing in lottery tickets just because you happened to get lucky and win the Powerball.

[harrylime]

From the referenced article:

The S&P 500 index is composed of the 500 largest companies.

Credibility lost...

[Call_Me_Op]

That's a common misconception (regarding the S&P 500).

[Akiva]

No, if you are e.g. working at the energy derivatives desk at one of the major investment banks and can't have your "book" beat the market, you are doing something wrong.

Sounds like insider trading to me.

The major banks and other market participants have significant institutional advantages that have nothing to do with insider information. Look there are proprietary trading firms (i.e. private companies that do nothing but trade the markets) like Jane Street that show profits day-in and day-out. But normal investors will never be able to achieve these sorts of returns.

That's comparing apples to oranges, though. You can't take a proprietary trading desk doing, say, interest rate arbitrage, etc and say the "beat the market." What market?

I've been using "beat the market" to mean that they post a Sharpe ratio substantially higher than what could be achieved with "normal" investments.

The stock indices? That's a faulty comparison. Besides, those trading desks operate with a lot more leverage than retail investors do, and they have a tendency to make a lot of money until they blow up spectacularly.

In point of fact, depending on the market, their returns can have positive skew meaning that large outliers are more likely to be positive than negative. It's just that the media only reports the few-and-far-between blow-ups...

They didn't beat the market. They aren't even playing in the same market. Ditto for hedge funds. That would be like saying you beat the market by investing in lottery tickets just because you happened to get lucky and win the Powerball.

I don't think you are reading what I wrote in context. My point up at the top was that, yes, businesses exist that actively trade the market for profit, but what they are doing isn't relevant for normal investors so you shouldn't worry about it or waste time and money trying to do the same thing. And what these guys are doing isn't gambling. They are providing liquidity for a fee. If these guys didn't make money, there wouldn't be a market to invest in.