John Bogle presented at this year’s Grant’s Spring Conference and made the argument for indexing as the way forward for investors. You can find his presentation slides here. Jim Grant offered some push back from the “active” side which raised the question – is indexing superior to specific security selection and which is the way forward for investors?
I tend to think that Bogle is on the right side of this debate though I also think he gets a few things wrong. Here’s a brief rundown of my view:
- We know that diversification helps to increase our return per unit of risk because the addition of uncorrelated assets reduces overall volatility in a portfolio. So it makes sense that the public has veered increasingly towards instruments which provide us with diversification because we are all trying to achieve the best returns per unit of risk taken. Index funds are a simple product that meets this growing demand for broad asset selection as opposed to specific security selection.
- Hyperglobalization has changed the way we view the world. We no longer reside in localized economies. We reside in a vast global system and we can better diversify our portfolios by expanding beyond our own borders and into the global economy’s financial markets. See also: Indexing is Macro Investing.
- Indexing is just diversified asset picking. That is, picking the S&P 500 means you’ve actively picked 500 stocks (out of tens of thousands in the global economy) in an efficient vehicle as opposed to trying to replicate the index on your own. And anyone whose “stock” allocation is comprised solely of the S&P 500 has deviated substantially from global cap weighting which renders them an active investor. In a world where stocks are now neatly packaged into tax and fee efficient vehicles we have all become “asset pickers” as opposed to just “stock pickers”. And while frictions matter to our total return the asset allocations we choose, maintain and change will ultimately be the primary driver of our returns. So the distinction between “active” and “passive” is a lot more blurry than Bogle presents it. See also: The Allocation Matters Most Hypothesis & The Myth of Passive Investing.
- Costs matter, a lot. Bogle’s cost matters hypothesis is hugely important. At the aggregate level, we all generate the market return minus the costs we incur. Reduce those costs and you increase your total return. Specific security selection is expensive in many ways. It tends to be time consuming, higher fee and tax inefficient relative to indexing. See also: The Cost Matters Hypothesis, Understanding Your Real, Real Returns & The Importance of Reducing Fees.
- Being less diversified offers you the opportunity to generate “market beating” returns, however, as I’ve argued before, this is the wrong goal for most investors. Most investors do not need to “beat the market”. They need to maintain purchasing power without exposing their savings to excessive risk of permanent loss. The allure of “market beating returns” is often used to justify paying high fees and higher taxes which fuels the growth in highly inefficient strategies. Perhaps most importantly, the financial markets aren’t where we “get rich”. The financial markets represent our allocated savings and most of us will “get rich” selling goods and services on the private markets long before we’re successful enough to sell that output on a public exchange. See also: Beat the Average Investor by NOT Trying to “Beat the Market”, Setting Realistic Portfolio Expectations & The Stock Market isn’t Where you Get Rich.
- Most “active” managers underperform their correlated benchmarks, but so must “passive” investors in the aggregate. After all, we all generate the post-tax and post-fee return of the aggregate of the financial markets. So this strawman argument against “active” investors is not as useful as some make it out to be. If you understand that we are all active to some degree then this debate becomes more about efficient active decision making and less about “passive investing”. See also: The Case for Index Fund Investing, Jack Bogle, Active Investor in Passive Clothing & Assessing the Performance of Passive Investors.
- It is irrational to argue against any discretionary intervention in a portfolio. We must all make active decisions in our portfolios when we establish our asset allocations, rebalance, reinvest, distribute, etc. Further, most investors do not have a portfolio time horizon that remotely resembles the textbook concept of the “long-term”. Therefore, some strategic asset allocation isn’t just intelligent, but probably necessary. See also: Problems with The Long-Term.
- Bogle likes to criticize ETF investing relative to traditional index funds because of the temptation to be more active (as if you can’t be active in a mutual fund just because it’s not trading in real-time?!?). Yes, the most active shares on the NYSE in any given day are ETFs. But the efficient asset allocator need not be involved in such highly active trading just because they utilize a vehicle that allows it. This is like arguing that we shouldn’t drive cars just because they have the ability to go over 100 MPH. This is very silly in my opinion. If index funds are Honda Accords then ETFs are Toyota Camrys. Both efficient, safe, low cost vehicles with slightly different costs and benefits. The costs and benefits of ETFs relative to index funds are important to understand and in many cases the ETF option is more tax and fee efficient. But ultimately, ETFs and index funds are very similar. See also: the Costs of ETFs vs Index funds & Calculating those Costs.
None of this means that micro investing (specific security selection) will go away. There will always be opportunities for market participants to make money focusing on micro investing. But for the vast majority of us who are just trying to allocate our savings in a prudent manner the future of asset allocation is almost certainly macro indexing.
* The title of this story is rather unfortunate as I don’t view the word “investing” as having the same meaning that the finance industry uses, however, if I wrote that “Indexing is the Future of Saving” then no one would understand what I was trying to say….Oh well.