Case against Index funds

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jay22
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Case against Index funds

Post by jay22 » Wed Aug 29, 2012 1:15 pm

I apologize if this topic has already been covered, but as part of my continuing new investor education, I wanted to know what you guys think are the cons of index funds? I know almost everyone here is swear by index funds, but when I read more about it, I keep on getting this impression that not everyone in the industry is as enthusiastic about index funds. I am slowly getting convinced that index funds give the best returns over a period of time (low costs, less effort being the prime reasons), why do people in the industry see it differently? I regularly see blogs, articles deriding index funds - they're not active investments, they don't even make an effort to beat the market, they will miss out on the next big thing because they are passive, etc. You thoughts? What do people like Buffet (who has a Midas touch) think about them?

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Re: Case against Index funds

Post by hlfo718 » Wed Aug 29, 2012 1:24 pm

People in the "industry" assuming you mean the financial services industry? Can't speak for the whole industry but I believe the ones who are not "convinced" are really the people who have incentive to push active funds like asset managers, sales people/brokers, and even publishers like Morningstar, money, fourtune, forbes, barron's... Think about it, if you are the exec for Janus, are you really going to praise index funds?

The con of using index funds is that you no longer need to make trades and hence you have more free time, if having more free time is a con.

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archbish99
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Re: Case against Index funds

Post by archbish99 » Wed Aug 29, 2012 1:27 pm

Taylor has a long list of quotes that he'll probably repost if we ask nicely. Buffett can (probably) outperform the index, because he has education, resources, and skills we don't. He recommends index funds for the average investor.

In short, though, you see financial media promoting active management for a very simple reason: self-interest. If indexing is the answer:
  • Fund managers must compete on low prices rather than skill, so the race to the bottom makes them less and less money over time
  • Financial news becomes boring, so financial media will lose viewership and therefore advertising revenue
  • Trading will be confined to large financial corporations who can demand volume discounts, rather than individual investors who generate high volume and high commissions
  • Advisors aren't really doing anything with your investments that another advisor couldn't do, so they have to justify the money you pay them with other skills, such as financial planning, or by lowering their fees
People can miss anything if they have enough financial incentive to ignore it.

The cons of indexing are that, yes, you'll miss the highest-performing company. If I could see each day's "market movers" screen a day early and pick up a few thousand shares of whatever was going to be up 20% overnight reliably, I could easily outperform any index fund. The problem is that if those companies can be identified in advance, they get bid up by everyone who knows they're going to shoot up, causing the price movement to occur sooner. So you need to know earlier still, and so on....

There's only way to guarantee that you own tomorrow's hot stock before tomorrow -- buy every stock. Of course, that means you also own tomorrow's dud, and that's what grates on most active managers' nerves.
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Re: Case against Index funds

Post by FabLab » Wed Aug 29, 2012 1:32 pm

jay22 wrote: I am slowly getting convinced that index funds give the best returns over a period of time (low costs, less effort being the prime reasons), why do people in the industry see it differently?
Self-interest? :mrgreen:
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Re: Case against Index funds

Post by Khanmots » Wed Aug 29, 2012 2:00 pm

When I had an Ameriprise advisor she wasn't allowed to recommend to me any fund that had a 12b-1 fee of less than 0.75% a year (which is basically an ongoing commission every year from the fund to the advisor company who sold the fund)

Why would Ameriprise put this restriction on her?

Self-interest at the expense of the investor permeates the industry.

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Re: Case against Index funds

Post by DSInvestor » Wed Aug 29, 2012 2:06 pm

jay22 wrote:why do people in the industry see it differently?
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Re: Case against Index funds

Post by Cut-Throat » Wed Aug 29, 2012 2:11 pm

There are 2 rules when it comes to Index Funds.

1.) Index Funds are for people that cannot predict the Future.

2.) Those that can predict the Future should buy a Lottery Ticket, which will have a much better return.

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Re: Case against Index funds

Post by ruralavalon » Wed Aug 29, 2012 2:12 pm

jay22 wrote:I apologize if this topic has already been covered, but as part of my continuing new investor education, I wanted to know what you guys think are the cons of index funds? . . . .
#1 Con -- No income for most of the financial services industry.
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Re: Case against Index funds

Post by rustymutt » Wed Aug 29, 2012 2:14 pm

"I keep on getting this impression that not everyone in the industry is as enthusiastic about index funds"

I think you answered your own question in that remark. Wall street doesn't makes as much money with index funds, as with active funds, and other creative devises to market to us. Hard to get enthusiastic about index funds, if they take earning away from you, and your company.
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HomerJ
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Re: Case against Index funds

Post by HomerJ » Wed Aug 29, 2012 2:16 pm

jay22 wrote:they don't even make an effort to beat the market
ANd they don't trail the market either.

Index funds beat like 70%-80% of their peers.

So, do you want $5000? Or do want to roll the dice and pick an active fund? 75% chance of $4000, 25% of getting $6000.

And you have to roll the dice every year. The 20%-30% of active funds that beat the index are NOT the same funds each year. If you pick an active fund and stick with it for 20 years, the odds are more like 99% you underperform the index, 1% you beat it.

So you have to pick the correct active funds each and every year in order to stay ahead of the index fund.

Or you can just invest in the index and get the market return. No more, no less. But the average market return has been pretty good for the last 100 years. Easily enough to retire on... No real need to gamble for 1% more return, especially since you have a much higher than 50% chance of getting 1% less return instead.

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Peter Foley
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Re: Case against Index funds

Post by Peter Foley » Wed Aug 29, 2012 2:52 pm

Without intending to do so, the September 2012 issue of Kiplinger's Personal Finance provides an endorsement for indexing. As part of their annual mutual fund rankings, there is an article titled "And the winners are..."
1-3-5-10-and 20 year returns are listed for a variety of stock funds (large cap, mid cap, small cap, etc). There is very, very, little overlap of funds over the different time periods. It begs the question, will the 1 year, 3 year, and 5 years winners of today make the 10 and 20 year list of the future? For many fund types the category averages compare poorly to their comparative indexes.

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Re: Case against Index funds

Post by bengal22 » Wed Aug 29, 2012 3:03 pm

If everybody indexed how many people in the media would be out of jobs? There would be no reason to forecast hot funds, hot sectors, top 10 fund list, fund ratings etc. etc etc. There would be a lot of "static" on television, less magazines, and blank newspaper print. There is really a whole industry out there that is supported by not agreeing with index investing.
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Re: Case against Index funds

Post by NYBoglehead » Wed Aug 29, 2012 3:07 pm

OP,

The financial services industry thinks index funds stink because they make less money off them. One of the reasons Vanguard kicks everyone else's butt in expense ratios is because they are based in Valley Forge, PA and not midtown Manhattan. No 70th floor offices with floor to ceiling windows. The person paying for the lavish offices with mahogany tables is the person paying 100+ bps for mutual funds that will underperform the market.

You will never meet a life insurance agent tell you need less life insurance, a landscaper who tells you your yard is fine, or someone who makes money from active money management tell you index funds are the way to go.

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jay22
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Re: Case against Index funds

Post by jay22 » Wed Aug 29, 2012 3:09 pm

Thanks for all the replies.

I do see your point and agree with you that it's the financial industry who wants to make tons of money which goes contrary to what the Index funds preach. But, when I see investment experts and certain financial blogs, I can't help but stop for a second and think, wait, do they have a point here? :)

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Re: Case against Index funds

Post by HomerJ » Wed Aug 29, 2012 3:20 pm

jay22 wrote:I do see your point and agree with you that it's the financial industry who wants to make tons of money which goes contrary to what the Index funds preach. But, when I see investment experts and certain financial blogs, I can't help but stop for a second and think, wait, do they have a point here? :)
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Re: Case against Index funds

Post by tludwig23 » Wed Aug 29, 2012 3:22 pm

jay22 wrote: ...But, when I see investment experts and certain financial blogs, I can't help but stop for a second and think, wait, do they have a point here? :)
Don't worry, it's a phase. You'll realize eventually that their points are not supported by either basic probability theory or by actual data.
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Re: Case against Index funds

Post by Kulak » Wed Aug 29, 2012 3:32 pm

- Built-in performance chasing. E.g., large growth and ridiculously overvalued tech stocks during the '90s. E.g., REITs (and on the bond side, % of TBM allocated to MBS) during the housing bubble. E.g., country-specific risk within a cap-weighted EM index. Etc.

- Institutional investors "gaming" the underlying index. E.g. with an individual stock on the border of being in or out of the S&P500 or Russell 2000. (Dunno how big a deal this is in practice, and TSM obviously avoids it.)

- Tax efficiency can be improved by active management.

Other Bogleheads will probably refute these, point by point.
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Re: Case against Index funds

Post by nisiprius » Wed Aug 29, 2012 3:36 pm

jay22 wrote:What do people like Buffett (who has a Midas touch) think about them?
I can't find a direct source--does anyone have one--unfortunately. But according to Bogle (in The LIttle Book of Common Sense Investing), Warren Buffett said "A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth."

Google did find me this, May 6, 2007
"A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money," Buffett said at a press conference.... Charlie Munger, Berkshire's vice chairman, said at the press conference that many investors actually fare worse in actively managed funds.
And this, August 26th, 2007:
If you are not a professional investor, if your goal is not to manage money in such a way that you get a significantly better return than world, then I believe in extreme diversification. I believe that 98 or 99 percent — maybe more than 99 percent — of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all — that is the way they should approach it.
.
Last edited by nisiprius on Wed Aug 29, 2012 3:44 pm, edited 2 times in total.
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Re: Case against Index funds

Post by Call_Me_Op » Wed Aug 29, 2012 3:37 pm

jay22 wrote:....why do people in the industry see it differently?
Simple. They see it differently because the commissions and higher fees of active funds end up largely in their pocket - instead of yours. Sound appealing?
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Re: Case against Index funds

Post by stevewolfe » Wed Aug 29, 2012 7:23 pm

I'm a fan of total market indexes on the stock side. I'm not a fan of indexing in subsections of the stock market, such as small value. There are a number of different indexes, companies change the indexes funds track (e.g., Vanguard 2003), the indexes are built around screens, etc - I just can't get excited about indexing subsections of the market. I'm also not a fan of total bond market index, but hey that's me and no, I don't have an academic library of research to back up those statements. :)

I stick with TSM, TISM and augment that with a couple active funds for tilt. And on the bond side I prefer I-Bonds, CD's and Stable Value fund (Vanguard).

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We don't know how "they see things"

Post by lawman3966 » Wed Aug 29, 2012 8:38 pm

jay22 wrote:why do people in the industry see it differently?
I take issue with your premise. We don't know that the industry sees things differently. We only know that they say that they see things differently. If one instinctively distrusts (as I do) everything one hears from a speaker having financial interests adverse to the speaker's audience (such as a financial advisor speaking to his potential clients), there is no mystery to the content of statements issued by the industry. They are salesmen arguing the benefits of the product (active management) they sell at a profit. If they were selling detergent, and arguing the benefits of their brand over their competitor's brand, the public would know to discount the statements. But, in the area of financial advice, statements from guys wearing $2,000 suits are (unwisely) accorded more credence than statements made by the detergent salesmen.

Here's one way to test the confidence of the advising industry: offer to pay an advisor a percentage of whatever the advisor earns in excess of the returns of a suitable benchmark index of stocks and bonds (so long the advisor agrees to reimburse you for any deficiency in the performance of their proposed portfolio with respect to that same index). Please let us know if you find any takers.

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Re: Case against Index funds

Post by midareff » Wed Aug 29, 2012 9:00 pm

jay22 wrote:I apologize if this topic has already been covered, but as part of my continuing new investor education, I wanted to know what you guys think are the cons of index funds? I know almost everyone here is swear by index funds, but when I read more about it, I keep on getting this impression that not everyone in the industry is as enthusiastic about index funds. I am slowly getting convinced that index funds give the best returns over a period of time (low costs, less effort being the prime reasons), why do people in the industry see it differently? I regularly see blogs, articles deriding index funds - they're not active investments, they don't even make an effort to beat the market, they will miss out on the next big thing because they are passive, etc. You thoughts? What do people like Buffet (who has a Midas touch) think about them?

and they make :moneybag :moneybag :moneybag that the financial industry is famous or infamous for, by telling you to buy an index fund with an .08% annual fee instead of their recommended fund with a 1.17% annual fee .. which has a reasonable chance (and the expectation) of underperforming your index funds by the amount of it's management fees, trading costs, researched salaries, advertising costs, etc., ..... .. for what reason again?

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Re: Case against Index funds

Post by Ozonewanderer » Wed Aug 29, 2012 10:04 pm

nisiprius wrote:
jay22 wrote:What do people like Buffett (who has a Midas touch) think about them?
I can't find a direct source--does anyone have one--unfortunately. But according to Bogle (in The LIttle Book of Common Sense Investing), Warren Buffett said "A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth."

Google did find me this, May 6, 2007
"A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money," Buffett said at a press conference.... Charlie Munger, Berkshire's vice chairman, said at the press conference that many investors actually fare worse in actively managed funds.
And this, August 26th, 2007:
If you are not a professional investor, if your goal is not to manage money in such a way that you get a significantly better return than world, then I believe in extreme diversification. I believe that 98 or 99 percent — maybe more than 99 percent — of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all — that is the way they should approach it.
.
This is probably the best argument against index funds. You won't become a Warren Buffet. What are the odds?

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Re: Case against Index funds

Post by abuss368 » Wed Aug 29, 2012 10:46 pm

jay22 wrote:I apologize if this topic has already been covered, but as part of my continuing new investor education, I wanted to know what you guys think are the cons of index funds? I know almost everyone here is swear by index funds, but when I read more about it, I keep on getting this impression that not everyone in the industry is as enthusiastic about index funds. I am slowly getting convinced that index funds give the best returns over a period of time (low costs, less effort being the prime reasons), why do people in the industry see it differently? I regularly see blogs, articles deriding index funds - they're not active investments, they don't even make an effort to beat the market, they will miss out on the next big thing because they are passive, etc. You thoughts? What do people like Buffet (who has a Midas touch) think about them?
Hi jay22,

I would recommend a good book on mutual funds by Jack Bogle.

Best.
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success."

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Re: Case against Index funds

Post by clueless_dude » Wed Aug 29, 2012 10:58 pm

Well.... we had a great chance to test whether active funds are worth the extra cost. The crash of 2008!

Can anyone make the argument that active funds did better than index funds in the case of the crash? Did the highly paid managers of the active funds predict the crash? Were they able to take evasive measure before the crash thus saving their investors?

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Re: Case against Index funds

Post by pkcrafter » Thu Aug 30, 2012 12:08 am

Can anyone make the argument that active funds did better than index funds in the case of the crash?
No. Here's the percent of active funds beaten by their index in 2008.

Exhibit 4: Percentage of Active Funds Outperformed by Benchmarks in Bear Markets
2008
All Large-Cap Funds 54.3%
All Mid-Cap Funds 74.7%
All Small-Cap Funds 83.8%

Data from the S&P Active vs Passive (SPIVA) report

http://www.standardandpoors.com/servlet ... lue3=UTF-8


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Re: Case against Index funds

Post by Stickman » Thu Aug 30, 2012 12:20 am

Below is a link so you can listen to Warren Buffett yourself, where he says the following:

"If you are not a professional investor, if your goal is not to manage money in such a way that you get a significantly better return than world, then I believe in extreme diversification. I believe that 98 or 99 percent — maybe more than 99 percent — of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all — that is the way they should approach it."
—Warren Buffett

Listen to him yourself:
Skip to the 1:12 mark of the following online video. Warren Buffet explains to MBA students at the University of Florida why he believes index funds are the best choice for most investors.
http://www.youtube.com/watch?v=P-PobeU4Ox0

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Re: Case against Index funds

Post by spotty_dog » Thu Aug 30, 2012 12:41 am

I think the case can be made that if you throw yourself heart and soul into investing, if you create a portfolio of 15-20 extensively researched common stock positions, if you live and breathe those 15-20 companies and do everything in your power to know the tiniest factor that will affect their performance -- ideally to the point that you can call the CEO personally on the phone, ask him if he pooped today, and extrapolate from that whether to buy more stock or sell everything -- then you have a fighting chance of beating the market by a couple percent. You even have a chance of finding some miraculous dark horse and really riding it to fame and fortune. (Of course, you have a nearly-equal chance of finding some unexpected lemon or missing some key signal in the tea leaves and losing a boatload.)

On the other hand, if you have a life and just want to hit the perfect balance of risk and reward while still living that life, then you can simply trust the market, and the loads of research that shows that owning the whole market -- plus some bonds to help calm risky volatility -- does the trick. Set it and forget it, except for every year or so when you rebalance. As the economy grows, so does your portfolio. As the economy slides, you rebalance into bonds and other uncorrelated assets and maybe you don't slide so badly. And you trust that, on the whole, between now and when you plan to use the money you're saving, the global cadre of companies of all shapes and sizes and flavors will more or less continue to grow and perform -- because if they don't, and the world economy crashes into a puddle of goo on the stock exchange floor, then we will have a lot of bigger problems than just the loss of our retirement savings.

And yes, Buffett thinks that the vast, vast majority of investors should be in low-cost well-diversified index-based holdings. Here's a fun quote from a book I read recently. "At the May, 2006 Berkshire annual meeting Buffett offered to bet $1 M that over 10 years, and after fees, the performance of an S&P 500 index fund would beat 10 hedge funds any opponent might choose." Nobody took his bet, I don't think.

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Re: Case against Index funds

Post by Cruncher » Thu Aug 30, 2012 1:39 am

Sorry is this has been mentioned:
...are the cons of index funds
It's boring.

It just keeps climbing, getting your fair share.

-C

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Re: Case against Index funds

Post by paulsiu » Thu Aug 30, 2012 2:09 am

The financial industry want to sell you stuff to make a profit. Index funds are a low margin item. All index fund follow the same index, so if they charge too much fee, they will fall behind. You also end up competing with Vanguard who's cost conscious and have an economy of scale.

No one except vanguard really wants to offer an index fund, they just do it to keep you as a customer so they can sell you other stuff that makes them more money.

Index fund are also a bit unamerican because you are settling for the average. Good luck finding the next Buffet.

Paul

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Re: Case against Index funds

Post by rgb73 » Thu Aug 30, 2012 3:45 am

I think the case can be made that if you throw yourself heart and soul into investing, if you create a portfolio of 15-20 extensively researched common stock positions, if you live and breathe those 15-20 companies and do everything in your power to know the tiniest factor that will affect their performance -- ideally to the point that you can call the CEO personally on the phone, ask him if he pooped today, and extrapolate from that whether to buy more stock or sell everything -- then you have a fighting chance of beating the market by a couple percent. You even have a chance of finding some miraculous dark horse and really riding it to fame and fortune. (Of course, you have a nearly-equal chance of finding some unexpected lemon or missing some key signal in the tea leaves and losing a boatload.)

On the other hand, if you have a life and just want to hit the perfect balance of risk and reward while still living that life, then you can simply trust the market, and the loads of research that shows that owning the whole market -- plus some bonds to help calm risky volatility -- does the trick. Set it and forget it, except for every year or so when you rebalance. As the economy grows, so does your portfolio. As the economy slides, you rebalance into bonds and other uncorrelated assets and maybe you don't slide so badly. And you trust that, on the whole, between now and when you plan to use the money you're saving, the global cadre of companies of all shapes and sizes and flavors will more or less continue to grow and perform -- because if they don't, and the world economy crashes into a puddle of goo on the stock exchange floor, then we will have a lot of bigger problems than just the loss of our retirement savings.

And yes, Buffett thinks that the vast, vast majority of investors should be in low-cost well-diversified index-based holdings. Here's a fun quote from a book I read recently. "At the May, 2006 Berkshire annual meeting Buffett offered to bet $1 M that over 10 years, and after fees, the performance of an S&P 500 index fund would beat 10 hedge funds any opponent might choose." Nobody took his bet, I don't think.
Ahem: http://longbets.org/362/

And I think Buffett chose the Vanguard Admiral S&P500 index fund.

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Re: Case against Index funds

Post by wriggly » Thu Aug 30, 2012 4:16 am

jay22 wrote:Thanks for all the replies.

I do see your point and agree with you that it's the financial industry who wants to make tons of money which goes contrary to what the Index funds preach. But, when I see investment experts and certain financial blogs, I can't help but stop for a second and think, wait, do they have a point here? :)
Apart from Bogleheads, I like to browse Abnormal Returns. It links to articles about active investing, technical analysis, macro predictions, the expected fate of technology companies, and even passive investing (Rick Ferri's articles often get included, as do any utterances from Mr Bogle).

Many of the articles are very well-written and quite persuasive.

While reading, it's useful to remember that:
1. on average active participants do exactly as well as passive participants, before costs.
2. these authors do not necessarily "eat their own dog food" and may not lose if their predictions turn out to be wrong.
3. a few of these authors may actually benefit by spreading misleading information.
4. even with the most obvious aberrations, "markets can remain irrational longer than you can remain solvent".

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jay22
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Re: Case against Index funds

Post by jay22 » Thu Aug 30, 2012 7:15 am

spotty_dog wrote:I think the case can be made that if you throw yourself heart and soul into investing, if you create a portfolio of 15-20 extensively researched common stock positions, if you live and breathe those 15-20 companies and do everything in your power to know the tiniest factor that will affect their performance -- ideally to the point that you can call the CEO personally on the phone, ask him if he pooped today, and extrapolate from that whether to buy more stock or sell everything -- then you have a fighting chance of beating the market by a couple percent. You even have a chance of finding some miraculous dark horse and really riding it to fame and fortune. (Of course, you have a nearly-equal chance of finding some unexpected lemon or missing some key signal in the tea leaves and losing a boatload.)

On the other hand, if you have a life and just want to hit the perfect balance of risk and reward while still living that life, then you can simply trust the market, and the loads of research that shows that owning the whole market -- plus some bonds to help calm risky volatility -- does the trick. Set it and forget it, except for every year or so when you rebalance. As the economy grows, so does your portfolio. As the economy slides, you rebalance into bonds and other uncorrelated assets and maybe you don't slide so badly. And you trust that, on the whole, between now and when you plan to use the money you're saving, the global cadre of companies of all shapes and sizes and flavors will more or less continue to grow and perform -- because if they don't, and the world economy crashes into a puddle of goo on the stock exchange floor, then we will have a lot of bigger problems than just the loss of our retirement savings.

And yes, Buffett thinks that the vast, vast majority of investors should be in low-cost well-diversified index-based holdings. Here's a fun quote from a book I read recently. "At the May, 2006 Berkshire annual meeting Buffett offered to bet $1 M that over 10 years, and after fees, the performance of an S&P 500 index fund would beat 10 hedge funds any opponent might choose." Nobody took his bet, I don't think.
This is probably the best argument here. One reason I chose to invest in Index funds and go with the boglehead approach is because I want to have a life. I don't want to become someone who is up all night thinking what might happen if the company you invested in screws it up somewhere. And yes, chances of finding someone like Buffer who has this uncanny midas touch are almost zero. So, might as well diversify, invest in index funds and have that risk/reward balance in life.

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Re: Case against Index funds

Post by Jerilynn » Thu Aug 30, 2012 8:18 am

if you create a portfolio of 15-20 extensively researched common stock positions, if you live and breathe those 15-20 companies and do everything in your power to know the tiniest factor that will affect their performance -- ideally to the point that you can call the CEO personally on the phone, ask him if he pooped today, and extrapolate from that whether to buy more stock or sell everything -- then you have a fighting chance of beating the market by a couple percent. You even have a chance of finding some miraculous dark horse and really riding it to fame and fortune.
Even with all that, you won't do any better than random chance.
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Re: Case against Index funds

Post by NYBoglehead » Thu Aug 30, 2012 8:30 am

paulsiu wrote:The financial industry want to sell you stuff to make a profit. Index funds are a low margin item. All index fund follow the same index, so if they charge too much fee, they will fall behind. You also end up competing with Vanguard who's cost conscious and have an economy of scale.

No one except vanguard really wants to offer an index fund, they just do it to keep you as a customer so they can sell you other stuff that makes them more money.

Index fund are also a bit unamerican because you are settling for the average. Good luck finding the next Buffet.

Paul
There is nothing un-American about index funds. You are not "settling" for the average, you are ensuring you receive a market return. The overwhelming majority of people do not work in the finance industry and want their hard earned money to grow to ensure a secure retirement. Most people have no interest in cash flow statemetns and P/E multiples, and by investing in index funds they will receive above average returns over time.

In regards to the next Buffet, he buys positions in companies and then takes an active role in the management of those companies. He is not just a stock picker. There will always be talented people who do remarkable things.

I am a 100% believer in index funds. My only concern is the apprehension of money managers to be active in corporate governance. They must vote for the interest of the shareholders and not just rubber stamp the board's recommendations. But that happens with both actively managed funds and index funds.

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Re: Case against Index funds

Post by Jerry_lee » Thu Aug 30, 2012 9:32 am

I don't know about a "case against index funds" based on alternatives available to all investors, but I do know index funds aren't perfect. They never have been and never will be (as with any strategy). For proof of this, just recognize how some index funds have "evolved" in the lat 5-10 years. Clearly Vanguard felt there was a case against their index funds in 2002, as they began planning a switch to MSCI that eventually went into effect in 2003. I am not smart enough to know how much of this was marketing on Vanguard's part (exclusive rights to MSCI indexes), and how much was index improvement.

While MSCI doesn't publish reconstitution details ahead of time (as Russell does), they also don't reach very far into the smallest and micro cap stocks either, so their "small" strategies aren't really that small. MSCI (per Vanguard's request?) still views their job to assemble indexes that mirror the common investable universe of active managers, instead of creating indexes that target the areas of the market with the purest asset class attributes. For example, defining value/growth by the upper and lower 30% (instead of 50%) of the market would give more consistent exposure to the value/growth dimension, but they sided with the active camp and not the academic camp on that one.

And just in general, of course, we know that all Total Stock Index funds are flawed to the extent that there is no "total" about them. Due to their cap-weighting, a few dozen mega cap stocks dominate their portfolio. That's fine if you are using them for the large cap portion of a portfolio, but if you are looking for additional diversification across the small and value dimensions, you better look elsewhere. But that is more of a "marketing flaw" than anything else, because TSM and S&P 500 indexes do work fine as LG components (assuming the S&P strategy is a bit flexible around reconstitution time).
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Re: Case against Index funds

Post by brianH » Thu Aug 30, 2012 9:54 am

I hope that the Buffett challenge reflects the *true* return to a simulated investor in both. Hedge funds have typically (though a some a bit lower now) charged a 2 & 20 fee of 2% straight management and 20% of any positive performance. Compared to Vanguard's VFIAX fee of 0.05%, that is a major disadvantage. That hedge fund will need to outperform by over 2% per year just to stay even. Over 10 years.

Of course, the challenge is kind of silly on its face. It's like betting that I, who sits at home, will outperform my buddy who heads to the casino for the afternoon. Simple math shows that I will win, if not in the short-term, certainly if we keep repeating this experiment for the rest of our lives.

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Re: Case against Index funds

Post by nisiprius » Fri Aug 31, 2012 5:56 am

Jerilynn wrote:
spotty-dog wrote:if you create a portfolio of 15-20 extensively researched common stock positions, if you live and breathe those 15-20 companies and do everything in your power to know the tiniest factor that will affect their performance -- ideally to the point that you can call the CEO personally on the phone, ask him if he pooped today, and extrapolate from that whether to buy more stock or sell everything -- then you have a fighting chance of beating the market by a couple percent. You even have a chance of finding some miraculous dark horse and really riding it to fame and fortune.
Even with all that, you won't do any better than random chance.
I'm open-minded about that possibility. But the point is that what spotty-dog has outlined is surely a necessary condition for success, even if it may not be sufficient. One of the reasons I index is that I think you are dreaming in thinking you can beat the market, unless you can do as good a job as the analysts and professionals who spend 40 hours a week following a couple of stocks, have access to a Bloomberg terminal and expensive databases, make trips to visit the companies they follow, and all that stuff.

I'm provisionally willing to believe Dr. Michael Burry was, in fact, an example of someone who did beat the market by intense full-time dedication to studying details of an asset class (the very worst mortgage-backed securities) that nobody else was paying enough attention to.

I read these Morningstar articles that go "Using Morningstar's Premium Fund Screener, we searched for small-cap funds with Morningstar Analyst Ratings of Bronze or better and Morningstar risk ratings of above average or high" and I think people must be nuts if they think they can succeed by spending twenty minutes with their brokerage's screener tool... or following some magic formula for stock-picking out of a book.

Oh, I guess where this comes from is some vaguely Puritan feeling that I want to understand what I've done to deserve to make money in stocks. I have no problem with the idea of buying some of the market and earning "my fair share." And I also have no problem with the idea that the players who actually influence "price discovery," who actually arbitrage valuation differences, who actually guide the flow of capital to the companies that best use it, are earning an honest living. I just don't believe that buying Apple stock because of a unique personal insight into iPods being cool is part of that process.
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Re: Case against Index funds

Post by Sunny Sarkar » Fri Aug 31, 2012 10:15 am

jay22 wrote:why do people in the industry see it [index funds] differently?
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Re: Case against Index funds

Post by Sunny Sarkar » Fri Aug 31, 2012 10:44 am

One very important thing to understand about index funds is the difference between mean and median. Index funds, by definition, aspire to achieve average/mean returns before expenses, but that's not the whole story (as the Wall St. marketing machine would like you to believe)...
Statistics recognizes different measures of an "average," or central tendency. The mean is our usual concept of an overall average - add up the items and divide them by the number of sharers (100 candy bars collected for five kids next Halloween will yield 20 for each in a just world). The median, a different measure of central tendency, is the halfway point. If I line up five kids by height, the median child is shorter than two and taller than the other two (who might have trouble getting their mean share of the candy).

The Median Isn't the Message by Stephen Jay Gould
The other important thing to understand is that it is a mathematical certainty that index fund investors always beat active fund investors as a group (something the Wall St. marketing machine will never tell you)...
Over any specified time period, the market return will be a weighted average of the returns on the securities within the market... From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return... Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

The Arithmetic of Active Management by William F. Sharpe
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Re: Case against Index funds

Post by Sunny Sarkar » Fri Aug 31, 2012 10:48 am

jay22 wrote:I apologize if this topic has already been covered...
You think? :wink:
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Re: Case against Index funds

Post by wshang » Fri Aug 31, 2012 11:19 am

Although it has been mentioned tangentially, a disadvantage of index investing is one has not dealt with systemic risk. With the market decline, we (BH's) did not escape the market carnage. There are other strategies which attempt to address this systemic risk - balancing off some idiosyncratic risk. These might incorporate options, gold or other types of investments.
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Re: Case against Index funds

Post by staythecourse » Fri Aug 31, 2012 11:38 am

I would say the biggest disadvantage of index funds is that you are giving up the chances of finding the stocks that are going to produce the ridiculously high returns you read about in the paper at the end of the year. Those are the one's that make you go "If I just would have invested in that stock in April I would have had a 30% return". That is the most seductive part of investing. The belief one can find the big winner out of the 1000's of stocks. Index investors have given up the chance of finding the right side tail stocks (the big winners) in exchange of avoiding the big losers (left side tail) stocks.

That is why you don't see Wall Street and financial shows discuss index investing. It is more entertaining to talk about which stock has become the next Apple.

The fascinating thing about index investing and diversification is you often will not have the highest return performance in any given year, but at the end you will likely do better then most eveybody else. The whole tortoise beating the hare.

Good luck.
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Re: Case against Index funds

Post by staythecourse » Fri Aug 31, 2012 11:40 am

wshang wrote:Although it has been mentioned tangentially, a disadvantage of index investing is one has not dealt with systemic risk. With the market decline, we (BH's) did not escape the market carnage. There are other strategies which attempt to address this systemic risk - balancing off some idiosyncratic risk. These might incorporate options, gold or other types of investments.
One can easily minimize market risk WITH index investing. That is what one does when they add a bond index fund.

Good luck.
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Re: Case against Index funds

Post by wshang » Fri Aug 31, 2012 12:20 pm

staythecourse wrote:
wshang wrote:Although it has been mentioned tangentially, a disadvantage of index investing is one has not dealt with systemic risk . . . .
One can easily minimize market risk WITH index investing. That is what one does when they add a bond index fund.
That is still systemic risk. BH's using a 3 fund portfolio did not escape 2008-2009.
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Re: Case against Index funds

Post by HomerJ » Fri Aug 31, 2012 12:39 pm

wshang wrote:
staythecourse wrote:
wshang wrote:Although it has been mentioned tangentially, a disadvantage of index investing is one has not dealt with systemic risk . . . .
One can easily minimize market risk WITH index investing. That is what one does when they add a bond index fund.
That is still systemic risk. BH's using a 3 fund portfolio did not escape 2008-2009.
Sure we did.

Image

Edit: Sorry that orange line is Intermediate Term Bond... Green line is Vanguard Total Bond Market.

Total Bond Market dropped like 3% or so during the worse crash in recent history. The fact that I was 60/40 stocks/bonds made a huge difference to my portfolio and my state of mind. Plus everything came back, so what systemic risk? Even if I was 100% stocks, I didn't lose money over the long run.

If one is close to retirement, increase percentage of your portfolio in bonds... Someone who retired in 2008 should have been in 20/80 or 30/70.... a 50% market crash equaled only a 10% or 15% portfolio drop... which most people can weather.

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Re: Case against Index funds

Post by nisiprius » Fri Aug 31, 2012 12:54 pm

wshang wrote:
staythecourse wrote:
wshang wrote:Although it has been mentioned tangentially, a disadvantage of index investing is one has not dealt with systemic risk . . . .
One can easily minimize market risk WITH index investing. That is what one does when they add a bond index fund.
That is still systemic risk. BH's using a 3 fund portfolio did not escape 2008-2009.
Please point to something in writing from some mainstream investing information source--magazines, Wall Street Journal, Morningstar--that

a) is dated before 2008, that
b) names a specific actively-managed mutual fund as being good in downturns, that subsequently
c) truly "escaped the carnage of 2008-2009."

By "escaped the carnage" I don't mean "fell 43% instead of 48%."

Of course there are "strategies which attempt to address this systemic risk - balancing off some idiosyncratic risk. These might incorporate options, gold or other types of investments." But do they address it successfully? Most of the "less risky" arguments I see in financial writing are hairsplitting. Hypothetical descriptions of what might do marginally better under imagined scenarios. Or small differences in risk through MPT-based investing, which if valid are exciting because you get that small degree of risk reduction without reduction in returns--but it is still small.

To "address" means literally "to talk to." As in "I can call spirits from the vasty deep." "Why, so can I, or so can any man; But will they come when you do call for them?" To "address" an issue is not to "solve" it.
Last edited by nisiprius on Fri Aug 31, 2012 1:00 pm, edited 3 times in total.
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Re: Case against Index funds

Post by NYBoglehead » Fri Aug 31, 2012 12:56 pm

The most ridiculous argument against index funds is that they will go down when the market goes down. No kidding. Of course TSM took a bath in 2008. It also allowed investors to scoop up shares on the cheap and since then have provided a nice return. Index funds are not magical and do not provide protection against recessions. No one has ever made that argument, and to suggest that they are not good investments because they will lose money when the market goes down is absurd.

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Re: Case against Index funds

Post by staythecourse » Fri Aug 31, 2012 12:57 pm

wshang wrote:
staythecourse wrote:
wshang wrote:Although it has been mentioned tangentially, a disadvantage of index investing is one has not dealt with systemic risk . . . .
One can easily minimize market risk WITH index investing. That is what one does when they add a bond index fund.
That is still systemic risk. BH's using a 3 fund portfolio did not escape 2008-2009.
Of course you did. The statement I made is MINIMIZING market risk and ELIMINATING it. A 60/40 investor loss was much better then 100%TSM investor in 2008.

Good luck.
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Re: Case against Index funds

Post by wshang » Sat Sep 01, 2012 1:32 am

nisiprius wrote:Please point to something in writing from some mainstream investing information source--magazines, Wall Street Journal, Morningstar--that

a) is dated before 2008, that
b) names a specific actively-managed mutual fund as being good in downturns, that subsequently
c) truly "escaped the carnage of 2008-2009."

By "escaped the carnage" I don't mean "fell 43% instead of 48%."
Nisiprius, of all posters . . . ! Challenge accepted ((data precedes 2008). BTW, I did not say active managed mutual fund.) This thread is about index funds (and the OP was asking about downsides). Here is a summary article written in 2010 looking back at 1,3,5 years. Although PERM is a mutual fund, I don't own nor advocate it as it does not allow tax harvesting. If anyone else knows of a strategy which had a 2008 -0.7% loss and better long-term draw down record, (avoiding the BH 3 fund systemic market risk) I would truly be appreciative.

http://www.myplaniq.com/LTISystem/f401k ... n?PID=1651

"The Harry Browne portfolio was the clear winner and was the exception – we will find out in the final article whether it proves the rule
With the exception of the Harry Browne portfolio, the drawdown ratios are uncomfortably high"

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