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Why Indexing Works

I am a big advocate of low cost diversified indexing in much the same way that most Vanguard funds work. The reason for this is simple – it’s been proven empirically that most active stock picking strategies fail to beat a simple low fee indexing benchmark.¹ But understanding WHY indexing works so well is essential to understanding why you should index. In this post I will cover the main reasons why indexing works and why it’s a smart way for most asset allocators to invest.

  1. The arithmetic of the market says that less active investors MUST, by definition, beat more active investors on average. As William Sharpe highlighted long ago, the average active investor must underperform the average passive investor. In other words, if the the average top line return of the market is earned by two investors then the less active investor will perform better because he/she will incur lower taxes and fees than a more active investor. Simple arithmetic.²
  2.  The arithmetic of alpha shows that no one actually earns alpha in the aggregate. In the aggregate we all hold one portfolio of all outstanding financial assets. Real-world investors do not earn the aggregate return of the market due to taxes and fees. So the aggregate investor must earn a return that is lower than “the market” portfolio. But the arithmetic here is daunting. The financial market and its frictions (taxes and fees) are akin to a NBA basketball game where the teams average 100 points per game. But at the end of the game the teams are docked 10 points by the referees and then 20 points by the league commissioner. The average team finishes each game with just 70 points and looks bad relative to its benchmark of 100 points. This is the equivalent of earning a 10% return in stocks and then being docked 1% for fees and 2% for taxes. Meanwhile, the average index is generating a return much closer to 10% (or 100 points in our NBA analogy) because their taxes and fees are lower. This is the uphill battle that so many active investors must overcome and the margin for error is incredibly thin as they are starting with such a significant disadvantage due to their likelihood of higher taxes and fees.
  3. Most active managers are selling the hope of market beating returns in exchange for the guarantee of higher fees. Wall Street has mastered the art of selling useless bullshit. And the way they sell most of that useless bullshit is by selling people the hope of better returns. The strange part is that no one in the world needs to actually beat the market. If you constructed a financial plan, “beat the market” would not be a goal. You just need to beat inflation and generate a reasonably appropriate risk adjusted return so you have enough money whenever you need it. Yeah, beating the market is nice, but it’s not necessary. Yet Wall Street sells this hope in exchange for high fees. And 9 times out of 10 they fail to follow through on that sales pitch. Indexing works because it avoids the alpha chase (the chase for market beating returns) and settles for an appropriate return rather than optimal (consistently unattainable) return.
  4. The alpha chase creates a conflict of interest. Most active managers cannot overcome the arithmetic of active management so they end up trying to beat the market by taking more risk. This creates a conflict of interest between the customer and the asset manager. In other words, the only way to guarantee that an asset manager might beat the market in nominal terms is to consistently take more risk. In bull markets these managers look like geniuses who have earned their fees, however, all they’ve really done is take more risk. This means that the manager has created a conflict of interest. His/her risk is career risk (not fulfilling their market beating promise) while the customer views risk as the potential loss of principle or lack of real returns. This means that the manager cannot on average beat the market and properly align him/herself with the interest of the customer. Indexing works because it eliminates this conflict of interest.
  5. Stock picking is hard because most stocks are losers. A recent study by Longboard Asset Management shows that just 25% of stocks are responsible for all of the markets gains from 1983-2006.³ This is largely due to the fact that so many companies fail and we don’t even know it. For instance, between 1980 and 2014 the total number of deletions in the S&P 500 was 320.4   Stock pickers have a huge hurdle to overcome as they try to avoid these failures and allocate to the 25% of the stocks that will generate the total market return. Meanwhile, a systematic index fund is automatically deleting these losers as they fail to meet the index funds requirements. In other words, the indexer is using a simple low fee rules based method for selling losers and letting winners ride.

There are many ways to index and many high fee active managers are creating their own index funds that are closet index funds in drag. As a simple rule of thumb it is best to stick with low fee market cap weighted index fund strategies. I am personally a big fan of most of Vanguard’s low cost indexing strategies, but I do have quibbles with many of these procyclical portfolios. I prefer a Countercyclical Indexing approach because I think it better controls for risks in the portfolio.

Additionally, in a strict technical sense we are all “active” investors because we all deviate from the one true “market portfolio” which is the aggregate of global stocks and bonds. But there are smart ways to be active (like low cost indexing) and stupid ways to be active (like day trading). In my opinion it’s smart to deviate from the Global Financial Asset Portfolio for several reasons: 1) Your risk profile may warrant it; 2) the GFAP is impossible to replicate perfectly; 3) bond aggregates don’t fully reflect total bond markets; 4) many bonds are stocks in drag and may not be appropriate for a bond portfolio; 5) tax and currency implications; 6) global stocks (like emerging markets) may add more risk to a portfolio than someone is comfortable with. So it’s fine to “sin a little” and deviate from a truly passive portfolio, but we should be mindful of how much we’re sinning and avoid the alpha chase which will very likely result in higher taxes and fees and worse overall performance.

¹ – See SPIVA Scorecards.

² – See, The Arithmetic of Active Management by William Sharpe

³ – See The Capitalism Distribution, Longboard Asset Management

4 – See The Agony and the Ecstasy, by JP Morgan 2014