Pragmatic Capitalism

Practical Views on Money, Finance & Life

The Biggest Myths in Investing, Part 4 – Indexing is Average

This is the fourth of a ten part series similar to what I did with “The Biggest Myths in Economics”. Many of these will be familiar to regular readers, but I hope to consolidate them when I am done to make for easier reading. I hope you enjoy and please don’t forget to use the forum for feedback, questions, angry ranting or adding myths that you think are important.

It’s been well established that picking stocks is very, very difficult.¹ In fact, it’s so difficult that 92% of the professionals can’t beat an index consistently. But in an effort to halt people moving away from these “active” strategies we often hear these managers saying that “indexing is average”. Whoa, that sounds lame, huh? No one wants to be average!  But how true is this really?

First of all, the term “indexing” has taken on a whole new meaning in the last 10 years with the explosion of index funds. Back when America was great the only type of index funds were big broad index trackers.² In today’s world you have an index for almost everything. And ETF companies are even making indices for their own strategies. It’s pretty clever actually. If you take an active mutual fund and create your own index to “track” systematically then you can actually call your “active” strategy a “passive” strategy. Brilliant. So there’s been a big blurring in the definition of active and passive in today’s new indexing crazed world because the whole idea of an “index” can cover everything from a plain vanilla S&P 500 index to a crazy derivatives trading volatility index . It’s all part of why I say that passive indexing is a myth

Anyhow, I think there’a myth in here somewhere so let me get back to that. The idea that indexing is “average” is intuitively attractive, but is actually wrong. For instance, if you bought all of the stocks in the market then you’d generate the average return. It would be like playing fantasy football and picking all of the players in the NFL. You would lose more often than not because there is no way you’re going to beat the team that has Tom Brady, Adrian Peterson, Antonio Brown or, well, any of the above average players in the league. But the problem is that this isn’t at all how investing works because there are frictions in investing that make these sorts of comparisons apples and oranges.

Using our fantasy football analogy – imagine that the average team has 10 positions and the average player scores 10 points. If you own “the market team” then you score 100 points on average because you generate the average weekly points at each position. But the best teams in the league score 110 points on average because they are loaded with top performers. By being able to pick the best players you “beat the average”. But the problem with investing is that we don’t earn the average return of the best performing financial assets. We earn the after tax and fee returns of these instruments. And this is where the idea of “average” gets muddled.

So, what happens to the fantasy football team with the best players when you add in frictions?  Well, imagine that your league commissioner docked you 10 points for “activity fees” every week and docked you another 20 points for “activity taxes” as a result of your more active player picking. Suddenly, your “above average” score drops to just 80! You’re actually losing to the average. Meanwhile, the league charges the indexer just 1 point for activity fees and 10 points for activity taxes leaving them with a score of 89. The indexer wins by incurring fewer frictions.

This is precisely what happens to more active fund managers and traders. Because they’re more active they tend to churn up more short-term capital gains. But they’re also charging you 1% or so per year. So, if the average return on stocks is 10% per year and the average top tier manager earns 11% per year then they’re beating the average before taxes and fees. But once you lop off their 1% fee and the extra 2% in taxes per year due to short-term capital gains they consistently underperform the market average as the annual performance data clearly confirms. And this doesn’t even account for the fact that it’s incredibly hard to earn that market beating 11% pre-tax and pre-fee return in the first place!

Of course, no one generates a true “index” return either because even the indexer incurs some frictions along the way from their various activities. But the kicker is that they earn a return much closer to the index average whereas the majority of more active investors earn a return that is less than the indexer’s average by virtue of their higher frictions. As a result, most indexers do better than the average active stock picker simply because they’re engaging in a form of asset picking that is more efficient after taxes and fees.

The allure to own something sophisticated and fancy sounding can often be an attractive sales pitch, but the reality is that simplicity usually beats sophistication, not because sophisticated is necessarily bad, but because sophisticated usually means high taxes and fees.

¹ – See the annual Spiva scorecards

² – I actually have no idea when America was great, when it got ungreat or why I just wrote a word that is definitely not a word.  

³ – The fact that we’re all active investors doesn’t change the importance of this discussion. But it is important when considering investment options in a world where more and more high fee advisors and portfolio managers are trying to sell themselves as “passive indexers” when they’re very often a high fee wolf dressed in sheep’s clothing. 

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