I assume people are referring to the S&P 500 index when they say they’re just going to buy an index fund.
The securities your index is compised of are weighted based on market cap. You are buying the most of the most expensive securities. You are putting the most money into the securities that have performed best.
They do worse than the market assuming they are a perfect reflection of their index due to expenses and management fees.
There is nothing wrong with management fees assuming you are getting value for them. Check out ABALX. This fund has been around since the crash of '29 and has substantially outperformed the S&P with much less volatility. It’s expenses run somewhere under .6%
I’d much rather have that than an index as it protects me against the inherent adverse selection that exists with index funds. There are other flaws, but I don’t want to get into an argument. Suffice it to say that there is no reason to own a managed fund in a bull market, but every reason in a bear. The measure of a good fund is it’s upside/downside capture ratio.
Or you could go for less risk, less volatility and historically higher returns with ABALX.
My friends would be foolish to take the medical advice I offer as I’m not a Dr.
That’s disingenuous. The DJIA, NASDAQ and S&P 500 are very consistent precisely because the companies that are counted in the index are consistent. If you peg yourself to an average that delists some and takes in others of course you’re not going to see any change. That’s why people buy into funds where people do the legwork for you for a small fee. If you do your research you’ll find plenty of funds that consistently beat the big indices. The ones that don’t die and are replaced, and the circle continues.
It is not at all hard to beat the indices.
Look, if you’re trying to say in a roundabout way that it’s bad to blindly invest your personal life savings (or the government’s Social Security kitty) in the stock market, yes, I agree. Uninformed investing is bad, and it’s irresponsible for anyone to pretend that it would be a great idea to shore up social security by just socking it in an index fund and letting the market work its markety magic. I couldn’t agree more. If you’re “investing in the market”, then yes, it’s a casino, you had bad luck (as often seems to be the case for you), and the market is “over” as far as you’re concerned. Walk away before you lose it all, and go put your money in some ripoff stable investment like annuities or something.
But if, on the other hand, you’re investing in individual companies based on a sound understanding of the fundamentals, there is absolutely no better time to be getting into the market than now (or a few months from now, give or take). There are still good companies out there which are on sale at prices that are frankly unfair to them, but a boon to investors who didn’t get caught up in the latest bubble.
We wanted to make a lot of money, but we had the strong sense that what we were doing was vital, important, and necessary. We were making the world a better place, making our company stronger, and we had a strong esprit de corps based on the fact that we were elite. Few understood what we did, or why it was so important.
All these feelings were valid. We were solving difficult problems. I am sure that the solutions that are being designed for today’s problems will be taken to extremes that will cause problems decades from now. I blame the extremes, not those solving the problems.
In this case, the mortgage/bond problem was just about the most noble thing a man could work on. Real estate was depressed. People couldn’t afford homes, credit was tight. By making mortgages saleable we freed up liquidity that enabled other people to buy houses at reasonable rates, started a boom in the housing market, and brought about a period of prosperity that was even able to see us through such disasters as the dot com bust, and 9/11.
These were extremely positive effects. The problem is that people extrapolate trends beyond what is reasonable, the margins got pushed farther and farther, and the whole thing collapsed.
What we did was good, and important for the most part, and I am proud of it, for the most part. We really had a sense that we were doing something very good.
Probably not. I can see that mistake. Personally though, I think they should hang for there new “market cap based” rating system. There is a direct cause and effect between that and the short selling that is bankrupting and distressing trillions of dollars of equities. Real companies, real people are getting hurt through this cowardly stupidity.
No.
This is the bottom. If it’s not, than this time things are different and you have a point. But each time we’ve had one of these corrections some people tell me the system’s broke, and this time it’s different.
So far they’ve been wrong.
Maybe this time it really is different. This feels different. Maybe this is the one that breaks the system.
Normally, these things do serve to consolidate the system, wipe out excess, and strengthen things over the long haul.
They had that big fire where like half of Yosemite burned down in '98, or so. I remember that being heralded as an unprecedented ecological disaster. Now the park is greener and more beautiful than ever.
Perhaps this is one of those “purifying fires.” A natural check on a useful feature of the credit markets that needs rebalancing.
Or, maybe it’s the end of the world. Who knows?
The funny thing is that they will end up putting a whole bunch of rules and regulations to stop this from happening again. What few understand is that we don’t have to worry about this happening again. Not for a long long time, at least.
What we have to worry about is the next disaster which will be different and unexpected and only obvious in hindsight.
There’s nothing really to be suspicious of. All an index fund is is a group of stocks selected because they represent a particular market (S&P 500), industry (tech, energy, etc), size (small cap, medium cap), risk level ( income, growth ) or country.
Basically, if you say “hey…I want to invest in energy startups!” you can either go find a bunch of individual stocks for energy companies or you can find some Emerging Markets Small Cap Energy Fund.
My GF and her friends all work for investment banks and rating agencies. Part of the problem with the mortgage backed CDO (packages of mortages bundled together and sold like bonds) was that the risk for the initial home loans was never adequately assessed. People lying on their applications or brokers lying in order to push the deal through. Lenders lying on whatever info they give the underwriters. So the lender packages up all these loans and sells them while the rating agencies assign their ratings mostly based on bullshit. They aren’t blameless either. Their customers are the investment banks that buy these instruments and they pressure the rating agencies to enhance their ratings so they can justify investing in them.
You don’t need to beat the market all the time. Just most of the time. People who know what they are doing like Warrent Buffet invest long term in companies that are fundamentally sound and run well. He’s not right all the time, but as long as he’s right 60% of the time, he’s making money.
My fraternity brother who’s a Wall Street trader tells me people ask him for stock picks all the time. His reply is “if I knew what stocks were going to do, I wouldn’t work. I’d just sit at home daytrading all day.”
The problem is that as technology advances, the markets become more efficient. That means all the information about a particular stock or bond is already included in the price and it becomes harder to make money. So what happens is the Wall Street guys create these elaborate derivative instruments to try and capitalize on inefficiencies in the market. Except I’m convinced that none of these guys REALLY knows what they are doing. I think they create these elaborate ‘systems’ like a dude at the track in the hopes of getting rich quick and then getting out before the bubble they create bursts. IMHO of course.
I’m not heavily invested in the market, but I’ve done well with my two biggest positions:
-My previous employer, a management consulting firm specializing in distressed companies. I was in a Employee Stock Purchase Plan so I get a good deal regardless.
-Netflix. Because I figured about a year ago that there would be a lot of unemployed people and people with no job and not a lot of money tend to watch a lot of movies.
Just want to chime in and say “Thanks” as well for the 3 part post, Scylla. I work in a position ancillary to the financial industry at the moment, and knew most of that already, and have (among other things) actually read an inch and a half thick CDO prospectus… and it was still an entertaining read. 
I will say that I am kinda glad I took the job offer closer to home rather than the one at Lehman in NYC when I graduated from college . . .
That has to be one of the strangest assumptions I have ever heard. Especially with you giving bad advice based on you oddball misconception. As I am sure you know an index fund is a fund that . . . . wait for it . . . . tracks a given index. Which can be just about anything. Countless studies have shown portfolios of index funds outperforming managed funds in bull and bear markets. They have further shown that if it was as easy as ‘buy low, sell high’ the market would have corrected that inefficiency.
Lovely explanation of CMOs, but I would leave the personal financial advice alone.
I would also like to point out the fallacy of Scylla pointing out ABALX (American Balanced) as a fund that ‘beats the market’ without even defining what market he is talking about. Its composition is wildly different from the S&P 500, but I have a feeling that is what you were comparing it to. It may well beat its proper benchmark, but you also would have to pay a sales charge in most cases to make the purchase and take on the risk that the managements past performance will not carry forward into the future. See Bill Miller of Legg Mason for an example of that risk.
In what way was the current disaster “unexpected and only obvious in hindsight”? To whom?
AFAICT, the “nobody could have foreseen this catastrophe” angle is being touted primarily by media and financial experts who were in a position to foresee it, but preferred to think positive and assume it wouldn’t happen. But there were plenty of other analysts out there who’ve been issuing warnings about potential dire consequences of recognizably dangerous strategies for quite a while now. Consider the points made in this 2006 article:
By the way, here’s an excerpt from Baker’s January 2005 piece:
[P.S. Excuse my interrupting myself to talk about me, but if I drop out for months at a time again after this post, it’s not that I’m not interested, it’s just that the teaching schedule is still really intense. Happy trails!]
Based on my experience (which is extremely extensive,) when people talk about an index fund they mean the S&P 500 index fund about 95% of the time. In excess of half the time they are referring specifically to the Vanguard S&P 500 index fund. If they are talking about other indexes they usually specify them, such as the EAFE, or Russell 2000. If they are looking at sector indexes or partial indexes they will usually say they are using ETFs or Spiders or the Qs.
However, if you are saying “an index” you are referring to the SP500 in some form, or people who know what you are talking will at least assume you are.
So. If you are in the industry, as I am, and use the terms daily, as I do, and that’s the way everybody, in your office firm and the whole investment community uses the terms, and has for the last 15 years or so… than it’s not really a strange assumption.
Yeah, I’ve heard that’s what they do. But if you say “index fund” and nothing else, convention is that you are referring by default to the SP500.
I know the appeal to authority is a logical fallacy. Nevertheless, that is a fact. I am an authority on this. I deal with it every day.
Similarly, if somebody asks you how the “market” is doing, they are referring to the DJIA, and not, say… the Hang Seng index or the farmer’s market down the street.
That’s a fact. 80% of funds underperform their respective indexes. Some of them do this by design. They seek to take less risk. Others simply aren’t that good. Others have a poor representative index. Of the 20% that do outperform some of them do so by taking more risk. Some do it by style drift. Some do a very good job and simply consistently outperform their indexes with less volatility. That’s why I gave an example of such a fund.
Really? It’s funny that I am not aware of any such study. Doubtless this is because it doesn’t exist. You have cite.
I think it’s wise that you do so.
Yes it is. I would argue that since it’s a balanced fund it is less risky than an all equity fund and would therefore have a lower expected return. The fact that it has significantly outperformed an all equity index over an extended period of time is a noteworthy achievement.
True and true. Not sure why the sales charge is such an objection. “Free” management is often fairly priced. In some cases funds with low expenses and management fees may profit through trading. American Funds discloses it trading costs and has been actively seeking to make mandatory such disclosure to reveal what it considers deceptive sales practices by other firms. Similarly, American Funds uses a team approach to management to avoid the Bill Miller all-star melt down syndrome, so far successfully.
To me. 20 years ago.
I concede your point and apologize. I have not stated my position clearly. I was referring to the long term. I don’t think anybody predicted this particular meltdown 20 years ago when its seeds were planted.
Right now, the seeds are being planted for future meltdowns of different varieties than today’s. They may occur 10 or 20 years from now. Some we will dodge and may not even notice, having dodged them. Others will hit us head on. Exactly what they will be is not predictable, only that they will occur.
Ok, lets back up for a minute. You seem to be saying that if you want a fund that will outperform its benchmark you just look for ones that have done so in the past. You invest in that 20% subset that has outperformed in the past and avoid those dogs that failed in their performance mission. That is one method that has been rather extensively shown not to work very well. Even the most favorable studies find your odds of future outperformance to be questionable at best.
So then what is the methodology people should be using to select the funds that have outperformed in the past and will likely outperform in the future? It has to be more than ‘look at its record’.
I apologize if I came across as an ass, but misbenchmarking is a chronic problem and results in grossly inappropriate sales techniques. Funds are sold as ‘beating the market’, meaning having a return better than the S&P 500, when they are a balanced fund with 50% stocks, a quarter of which are outside the US. If one is going to compare performance with an index fund it needs to be the appropriate blended benchmark.
I prefer a diversified portfolio of index funds because of the low cost, low turnover, lack of manager risk, tax efficiency and style purity of the allocation. I prefer not to wonder if my fund manager achieved his past outperformance by luck or virtue and the track record of manger outperformance turning to underperformance leads me to my decision.
The good folks at Altruist advisors and Bogleheads.org have kindly accumulated some links that support that philosophy. See here, note that though this goes to a forum it is not a collection of message board posts:
http://www.bogleheads.org/forum/viewtopic.php?t=173
http://www.altruistfa.com/readingroomarticles.htm#PassiveActive
I would be curious to have a cite of a tested methodology that a layman could follow that would allow one to find funds that would consistently exhibit the future outperformance we would all like to have.
You seem to argue from a positoin of authority because you use these terms every day, but without evidence to support the postion it doesn’t mean much. Most investments are sold be screening for the ones that have done well and implying that you have culled the dogs and are left with the cream (to badly mix a metaphor). I would argue that just doesn’t work.
I’d just like to add a word of thanks to Scylla for the very helpful analysis of how exactly these mortgages turned into such a meltdown.
I’m really rather interested in this fund versus index argument, however. Is it true that market cap determines the composition of the index?
I suppose it is almost axiomatic that investing in an index during a bear market would be pointless, but then again, as a low-risk investor seeking to start a nest egg, the scheme of “buy a fixed dollar amount every month, it automatically slows down your exposure as the market goes up, and vice versa (a.k.a buy low, don’t buy high)” seemed to me a sensible proposition.
I hear you that a well managed fund would outperform an index, but where would I start looking to see if such a fund would actually do so, and continue to do so? The internet is full of financial crackpots pushing their personal pet theory, and investment banks full of financial conmen pushing their personal bank balance.
Sometimes, I start thinking that maybe “under the mattress” is a good investment policy.
I sympathise, but index investing makes this easier. The problem I see with the idea of spurning index funds in down markets is that it presumes that your entire allocation is in stocks and that managed funds know when to sell and avoid the downturn. There simply is not evidence this is the case.
An investor would first decide how to allocate the money. So you might decide, for example, to have 40% Domestic Stocks, 20% International, 30% Bonds and 10% Real Estate (I made this up off the top of my head, this is not actual advice). You then either choose a fund that combines those elements or own four funds covering those bases. Your bond allocation is the risk control. You aren’t counting on someone to know when to move out of stocks, you control how much stock exposure you have.
A good company like Vanguard has asset allocation models that can help you develop your own plan and decide what level of risk is appropriate for you.
You have to look pretty carefully at what the criteria are. In one way, you are correct. In another, not.
If, for example, you look at three year trading periods and simply invest in that proportion of funds that beat their index than, indeed, you are correct. Those funds typically fail to outperform going forward. You have picked yesterday’s winners. The conditions that allowed those funds to outperform no longer exist.
Why? I think it depends on how you look at its record. If you’re focussed on current five star funds, or 3 year performance figures than I indeed think you are being foolish.
If, on the other hand, you are looking at consecutive rolling 10 year performance figures and upside downside capture ratios than I think you are not so foolish, and perhaps… wise.
Apology accepted and I agree with your latter statement.
Not necessarily. While misbenchmarking is a problem, there is not an appropriate benchmark for every fund. I happen to think that a team managed, disciplined investment strategy that has demonstrated less volatility and risk as measured by beta (and the implied consistency of returns that suggests) with a higher return than the S&P 500 consistently when measured both absolutely and by consecutive rolling 10 year periods, demonstrates that there can be better alternatives than simply buying an index. It doesn’t prove anything for the future, but you can’t do that with antything. I find it compellingly indicative.
Taking a quick glance at your cites, I’ll trust you to correct me if I’m wrong, but it doesn’t seem to me that they are truly arguing against managed money. A pretty compelling argument that can be made these days (and one that’s attracting a lot of money) is that you can passively manage indexes and partial indexes, and have the benefits of management without the drawbacks of style drift, potential underperformance, etc.
The way to do this is to create a tailored portfolio out of index funds (or ETFs these days) to properly diversify yourself according to your risk tolerance and investment goals. You then rebalance periodically or as market conditions dictate or your goals change or according to whatever specific discipline you are following.
Is that the essential nut?
If it is, than I am very familiar. It’s a good strategy. I approve. I think it has strong merits. I am a follower of several such ETF strategies myself.
Passive management is still a form of management. You are not simply blindly buying an index. You are tailoring and managing indexes. Agreed?
I still maintain and stand by my original argument that one is foolish if they simply “buy an index fund.” That does not seem to be what you are advocating.
I repeat. Tailoring a portfolio of indexes to your specific needs is a form of management. It’s a good form, IMO.
These are as easy to produce as they are valueless. Typically they are called hypotheticals. They show you what would have happened had you followed a given investment strategy in the past. It’s easy to find or produce a strategy through backtesting that looks great on paper. How it goes in the future is a different story. That applies equally well to any strategy.
That sounds like a dodge, but it’s not. In the whole world, there’s about 25 funds that I like. They are all very unique.
I would agree. You’re methodology while valid doesn’t do much different. If we are talking about an investment discipline than I will share mine. I would argue that you should not seek performance. You cannot buy performance as it is nobody’s to sell. Anybody that is trying to sell you performance is lying whether they are aware of it or not. You can’t control it, and you don’t know what it will be. Ergo, you can’t manage it.
What you can do though, is manage risk… partially. What you need to do is make sure that you are potentially being paid appropriately for every risk that you are taking. You need to make sure that you are not taking risks for which you have no possibility of getting paid. You need to seek to manage risk, not performance. You need to make sure that the risk level is appropriate for your goals and tolerance.
If you do that extremely well, you should, over time tend to receive a return appropriate to the level of risk you have taken.
After 20 years, that’s my opinion of managing money and that’s my investment discipline.
Thank you.
Many. Even most. The S&P 500, yes.
It’s called “dollar cost averaging.” It’s an exceptionally good way to build wealth. I would argue that after you build it, a different strategy is called for to manage it, but I think dollar cost averaging is a great idea.
There are excellent advisors out there, and bad ones. Same goes for Doctors, lawyers and handymen. I answered your second question first because it’s the easy one. For the first question I would say this: There is nobody that can tell you that any given fund is going to outperform in the future regardless of how well it has done in the past, or how consistently it has performed.
By that same token, nobody can tell you that any given index is going to provide a desirable or acceptable return in the future, either.
I happen to believe that a fund with superior long term performance (ten plus years, 40-50 is even better,) with low volatility, high consistency and a strong historic upside/downside capture ratio is a better candidate for investment than a market-cap weighted index fund for a variety of reasons.
I’ve already mentioned some. Another is that index funds are gamed. For example, AIG is likely to drop out of the SP500. For some reason I want to say Cisco will replace it, but that’s just a guess, and I think it’s wrong. Anyway, if CSCO is added into the SP500 it will happen on a specific day. In anticipation of this, the stock price is likely to move up significantly. Investors and fund managers will know that the stock is going to get added. They know that at a given point in time, every SP500 fund will have to buy CSCO. They buy it first and drive it up. Then the funds buy it and drive it up further. Once all that buying stops the stock typically drops a bit. You end up with bad execution on the buy in an index fund because of this. The same thing happens on the downside.
That’s a strong and aggressive investment in dollars versus other currencies and against inflation, so that carries its own risks as well.
Scylla, actually I think we mostly agree.
What I think is at the heart of my questioning comes down to this:
Take an average joe. Someone who does not know what a rolling ten year period, or upside capture is. How do you advise them to invest? A complicated strategy may or may not work, but it is not easy to understand or execute. If you walk down that path you are likely to leave Joe more confused and paralyzed by indecision. So the next step would be to hire an advisor who can execute a strategy for you. The problem there is that the vast majorty of those advisors are picking funds based on performance and taking a hefty fee for making the same mistake you would have made on your own.
The question of whether it is possible to outperform is ultimately less interesting to me than the question of what path a reasonably prudent layman should follow. To me, controlling the things you can control: cost, taxes, asset allocation - is the first step. I would then eliminate the risk that you don’t have to take, which is manager risk. A good asset allocation using index or low cost, low turnover active funds (I am thinking of Vanguard funds here, but some others qualify) seems to offer the best combination of ease, risk control and long term success. By rebalancing you stay on track and are automatically selling high and buying low.
If one had, or wanted to acquire, specialized knowledge you may be able to outperform that portfolio, but that is beyond most investors desire to learn.
Sticking to index fund vs managed fund investing …
So accepted that most managed funds underperform their appropriate indices in both bull and bear markets you argue that some smaller universe of managed funds have over a fairly long time period outperformed the indices, by enough perhaps to offset their management fees.
Your argument then rests on the belief that past performance of these funds predicts future results if one looks at “consecutive rolling 10 year performance figures and upside downside capture ratios” … now of course I’d love to see a study that actually showed that such was true, not a fund or so for which it has been true so far, lest you want to be disproved with counterexamples that did well for one ten year span and lousy over the next ten, but short of that I will argue why it seems unlikely that it would be true-
The performance of these exceptional historically outperforming funds rest not on some magic formula or on some corporate philosophy, but on the skill of a few exceptional stockpickers managing the funds. How long do these stockpickers last? A decade? Sure. For the next two decades after that? Less likely. Pick the fund that did well for ten years and you may be choosing it just as the critical stockpickers leave, or will be leaving.
Seems like a poor way to choose where to park your money for the next twenty years.
Again, I think a reasonably intelligent person can pick their own and do, on average, at least as well as the indices. If I can, any one can. But it requires a tolerance of risk, a bit of backbone, enough to diversify with, and a willingness to research out your ideas. Short of that the average Joe needs a fund or two. The average managed funds will underperform over time compared to a mix of index funds that reflect the broad market including small caps, mid caps and large caps (I here specify not just a S&P500 tracker). Picking managed funds that have outperformed is easy but picking ones that will outperform is hard, your proposed method notwithstanding.