Hi. I read on here once that over the long term, an index fund tracking either the overall market or possibly the S&P 500, would outperform most financial advisors.
I am looking for a cite to back up that claim. Do you know of one?
Fama and French, original research here:
Summarized by them here
Just to add: the F&F paper looked at actively managed mutual funds, weighted by assets. The guys managing those large funds are the best in that business. (Although there are smarter guys running hedge funds). If you are considering brokers or advisors giving you personal financial advice - you can guess at the level of their relative competence.
If you take personal financial advice, you should ensure that the advisor is paid only a fixed hourly rate, and that the advisor focuses only on assessing your personal financial needs, perhaps tailoring a risk-of-loss profile and investment time horizon that suits your circumstances. Stock tips, whether in terms of specific stocks or market timing, are worse than useless. Invest passively, or do your own research if you want to entertain yourself, but don’t kid yourself that either you or any advisor are likely to beat the market through anything but luck.
That’s absolutely correct, and one of the reasons is that financial advisors typically charge the client. Those fees add up.
If you want an in-depth look at that, I highly recommend The Little Book of Common Sense Investing, by John Bogle. The takeaway–“The best way to beat the market is to aim for average.”
Another book on the subject is A Random Walk Down Wall Street by Burton Malkiel. Note that I have not read it, but it argues against the idea that one can regularly beat the market average.
How about a video? This Frontline piece is a real eye-opener.
Also check out the John Oliver segment on 401k’s from his 12 June 2016 show. Not on YouTube yet but it will be.
At a more fundamental level, Sharpe’s The Arithmetic of Active Management explains that by definition, the average passive investor performs exactly as well as the average active investor. If active management fees are higher, then active investors must, on average, underperform.
In other words, the active investors definitely can’t all outperform: for every dollar of excess returns that one investor achieves, another must underperform by a dollar. In practice, active mutual funds have on average closely matched the market before fees, and underperformed after fees. Proprietary traders (high-frequency trading shops, market-making operations inside banks, etc.) outperform, and retail traders underperform.
This is trivially true since all stocks are always owned by somebody somewhere. Suppose we start out with only passive investors who each own small amounts of every stock in the entire market. If an active investor comes along who wants to buy stock XYZ, then somebody has to sell it to him, thereby creating a second active investor who owns the entire market except XYZ.
But there are still valid empirical questions about how various subsets of active managers perform. It’s not totally implausible a priori that active mutual funds might outperform at the expense of (say) stock-picking individual investors or pension funds. Empirically, of course, they don’t.
I’m too lazy to gather all the citations, but I believe that most studies of active mutual funds show very slight outperformance before fees, presumably at the expense of retail investors etc. They show underperformance after fees, though. Hedge funds show a similar pattern, with higher outperformance and higher fees.
This implies that active managers really are more skilled than the market on average. Investors just overpay for that skill. So the managers are “double-dipping”, extracting value from both their counterparties and their own investors (which I guess is further evidence of their skill?).
I don’t disagree with all the arguments against active management. But still, investing in an index fund feels like cheating off the most mediocre kid in your class, rather than cheating off the smartest kid in your class.
If I could tell in advance who the smartest kid in the class was going to be, I wouldn’t have to copy!
I index all my investments. I may never hit it out of the park, but I’ll never under-perform, and there’s no big fees draining my account year after year.
As an added bonus I really only look at my accounts once a year when the new money goes in (and it really adds weight to my arguments with family members when I outperform them while investing less time per year than they spend per day)
Since OP’s question has been answered, tangential remarks are in order.
This is a good point, but it may be somewhat misleading. S&P 500 index funds are not completely passive — they buy stocks which enter the S&P list and sell those which exit. And the S&P listing is itself a type of endorsement (partly self-fulfilling, due to the index funds themselves!) It would be interesting to see how results compare with total passivity, e.g. a fund which bought the S&P 500 stocks 30 years ago and never traded even when S&P changed its lists. (And, BTW, do S&P funds also have to respond to other market-cap changing actions, e.g. selling some of their shares when the company does a buyback?)
Moreover, an S&P index fund (or even a “Boglehead” mix) does not react to money flows between markets. More than 60% of the world market-cap now has a primary exchange other than NYSE or NASDAQ. A “purely passive” all-market fund would have 60% of its money invested outside the U.S. — and would be faring much worse than U.S. investors.
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On another matter, I once read an illuminating fact. If Fund X gets, say, a 10% return, the typical Fund X investor got only a 8% return! (I don’t remember the exact stat, but IIRC the differential might have been in a 2% ballpark.) The reason for this differential is that, regardless of whether Fund X is passive or not, its investor may not be. The typical investor will be “timing the market” and, due to the way fear and greed operate, probably mistiming it.
As Sharpe writes, “First a market must be selected – the stocks in the S&P 500, for example”. But the “market” could be anything. You could invest passively in all the local pizza restaurants (if the owners were willing to sell shares), or all Hummel figurines, or any other category of assets. It’s just that “the stocks in the S&P 500” is a category of assets that are liquid and easy to trade, and seem reasonably likely to have positive return.
A “completely passive” fund would have to buy a proportionate share of every asset in the world, including single-family houses, private businesses, gold, diamonds, etc. That’s obviously not practical, and the question of where to draw the line–exclude microcap US public stocks, include small-cap Indian public stocks?–doesn’t have one simple objective answer. Any “passive” investor is passive in a particular market, but probably active in others.
Not quite the same thing, but Vanguard’s VTSMX holds almost all US public stocks. It almost never trades. It tends to slightly outperform the S&P 500, perhaps because smaller stocks tend to have greater returns, and because it’s less susceptible to front-running of index changes. The difference is pretty small.
That is an excellent question. Likewise, do they participate in a follow-on offering by an index member? The answer seems like it should be “yes”, but I don’t know.
For example, Vanguard’s VTWSX. It is faring rather worse than US investors.
The typical phrases are “time-weighed” and “dollar-weighted” returns. Index funds suffer from this too, of course.
Here’s a listing of the percentage of actively managed mutual funds outperformed by their respective S&P index over the 10-year period ended December 31, 2015:
https://us.spindices.com/documents/spiva/spiva-us-yearend-2015.pdf
Pretty pathetic.
Research has been cited with empirical evidence, but note that this is not a ‘claim’ but an axiom, stated exactly and under certain limiting assumptions.
It’s not that index funds will outperform ‘most’, advisers as in the number of advisers. The axiom is as follows. All investment 's invested in a given index will get the index's return minus aggregate expenses. Therefore if active management/trading incurs more expenses on average than indexing, the average actively managed/traded must get a lower net return than the average invested in an index fund. IOW for every of pre-expense outperformance v the index, there must be a $ of under performance. Investors in the index in aggregate cannot beat the index pre expense by definition, so the body of investors as a whole with higher expenses (actively managed) must trail those who index if they do so with lower expenses. This doesn’t need a cite.
The empirical question is whether there’s a practical difference between the real world of active fund investing and the assumptions in the axiom. For example, decades ago a larger % of stocks were held directly by individuals. So it was plausible to hypothesize that active fund managers on the whole beat the index after expenses, and the under performance was concentrated in the larger body of stock held and traded by individuals directly. Today that’s a lot less plausible.
Or as has been mentioned in the thread, the axiom has greater limits if applied to an index that’s a small subset of the total market. If there’s enough inefficiency generated by stocks being added and subtracted from the index, actively managed 's which don't limit themselves strictly to the index could on average outperform passively managed 's which do, even with higher costs. Practically speaking this is implausible when it comes to the S&P 500, but for example it is more plausible when it comes to an index like the Russell 2000 US small cap stock index (OTOH that’s a reason a lot of small cap index funds don’t track the Russell 2000).
Then more broadly, there might be forms of active management which access asset classes outside public traded stocks (private equity, direct real estate investment, commodities, and on and on). The axiom doesn’t directly deal with whether there are risk/return/diversification benefits by investing in things other than publicly traded financial assets.
But for practical purposes the axiom holds. Unless you think you can choose a manager who will be significantly better than average manager in the future, you’re more likely than not to do worse with actively managed long only stock only funds than index stock funds, and especially those with relatively higher management fees among active funds. Or IOW the challenge just shifts from one intractable problem (picking the stocks yourself which will outperform the index in the future, risk adjusted) to another (picking the manager who will outperform other managers in the future, risk adjusted).
(Bolding mine.)
The hedge fund guys aren’t necessarily smarter! There’s a famous bet between Warren Buffett and Protege Partners that the S&P 500 would outperform a hand-picked portfolio of hedge funds. Buffet picked an index fund from Vanguard, Protege picked 5 funds of their own choosing (the exact funds haven’t disclosed). 8 years in, Buffett is up 66%; Protege is up 22%. I’m not sure whether that is accounting for fees or not. So in this case, there are at least 5 hedge fund managers massively underperforming the market.
The potential flaw in the S&P v hedge fund comparison is that the latter might be trying to optimize return for risk, or return for lowest possible correlation with the return of the S&P, not to correlate 100% with and beat the S&P in absolute return.
That said, there’s a more basic flaw in the logic which just looks at the relative capability of individual personalized financial advisers, big mutual fund managers and hedge fund managers. It’s directly relevant to themhow capable they are, but not to the investor. It’s only relevant to the investor is how much value they add after expenses. The HF performance used in the comparison are indeed after expense, and nothing else would be relevant from outside investor’s POV. To believe a more expensive manager is better for you, you don’t just have to believe they are smarter than a cheaper manager, but smarter by more than the additional amount they charge.
This gets back the axiomatic relationship laid out above. In aggregate, investing within an index of publicly traded stocks, it’s mathematically impossible that they could be on average. To benefit by picking one, you must have the talent to predict which of them will perform better than average after expenses. Why does a particular investor think they have this talent?
Again HF’s also can relate to certain of the limits of the axiom, as in first paragraph. Might they pursue non-stock picking strategies of low correlation of return to the S&P? But I think it gets into the weeds for most people. Even Buffett who is a genius in some ways is misunderstanding to think you can prove alternative investment strategies false to prove they don’t return as much as the S&P. Say the risky S&P’s expected return is 7%, riskless bond expected return 2%. Would an alternative strategy that yields 4.5% with moderate risk and 0% return correlation w/ the S&P be obviously stupid as a added feature to a portfolio of S&P and bonds? No. So the scope has to be limited to people trying to pick stocks to beat the S&P, or else other variables enter in and the axiom might not fully apply.
You raise great points for the general case of hedge funds vs the index, but in this bet, the hedge fund dude knew his objective was to outperform the index over 10 years, after fees. And he could hand pick the funds to do that. He’s still losing! If the hedge fund guy didn’t think it was an appropriate comparison, why did he take the bet? But yes, there are subtleties that limit its generalization.
The ten-year scope of the bet was intended to help average out risk portion. As for hedge funds “hedging” against the general market, that was the original source of the term “hedge fund,” but do they still present themselves that way?
Of course it’s not true that no managers outperform the market. I think the Valueline algorithm outpeformed the market for many years, no? But by the time average investors would be tuned into Valueline, enough market players were relying directly or indirectly on linear regressions like those Valueline ran, that those results were factored into the “efficient” market prices.
I think one reason fund managers have trouble beating the market is the fund’s need for diversification. It’s much easier to come up with three great stock-buying ideas than to come up with thirty of them. I’m sure many ordinary investors have outperformed the market hugely just by playing a single stock. I certainly wish I’d put all my money into Phillip Morris and just closed my eyes! (It may not be too late — MO has hugely outperformed over the past two years. Just don’t blame me if a progressive Congress suddenly presents the company with a trillion-dollar lung cancer bill. :eek: )