Markus Muhs - Aug 06, 2019
Many people espouse index funds because of their low cost and the overall less-than-stellar track record of active management. Well, here are a few more reasons why indexing trumps active investing.
I’ve written a couple of blog posts in the past about indexing versus active investing. As time goes on, more academic research comes out and it becomes less a debate and more a matter of whether we want to believe in facts and evidence or whether we want to continue to believe that active stock-picking is the way to go.
Index and factor investing has largely taken over my own investment philosophy, and indeed the lion’s share of allocations in the Muhs Elementum Portfolios. Here’s why.
A little personal history
Let me start with a bit of my own history where indexing is concerned. I think I was a teenager and just starting to learn about stocks and the markets and wondered… they keep reporting on the TSX Composite (or TSE Composite as it was then called) and Dow Jones (not a real index) indices… can’t we just invest in those? At that time, in the mid-90s, the first S&P 500 index ETF, SPY, was still in its infancy. TD launched the world’s first ETF in the form of the “Toronto Index Participation Fund” a few years earlier, which would later become XIU (ironically, now an RBC product). John Bogle of course had that little mutual fund shop south of the border called “Vanguard” that was not yet offering ETFs and a few decades away from offering anything in Canada.
When I became licensed as a mutual fund dealer with a bank in 2006 I noticed that in the bank’s big glossy brochure of mutual funds there was mention in some back pages of “index funds” which sported lower management expense ratios (MERs) than the active funds. I figured lower costs were better for the customer, so in my early days I sold those index funds, only to then have a co-worker tell me that I shouldn’t be selling them because the commissions are much lower (indeed, it was 1-1.35% on actively managed funds back then and 0.25-0.5% on index funds/portfolios).
For years I sold mutual funds with the bank and totally drank the Kool-Aid on active investing. The bank paraded their star fund managers around; the best of whom were closet-indexers (I don’t want to be naming names here, but generally the ones managing the bank’s huge Canadian dividend funds) and the worst of whom were serial destroyers of capital (one guy who managed a now defunct “global sustainability” fund for the bank can be seen today on Twitter, proclaiming that Beyond Meats is the be-all-end-all).
Eventually, after my transition to Canaccord Genuity, I went back to thinking the way I did as a kid: what’s wrong with indexing? We always refer to the S&P 500 or the TSX Composite as some measure of the strength of the U.S. and Canadian stock markets; or the MSCI indices when looking at the rest of the world. Back in the day the fund companies used to give out Andex Charts (they look like this) to illustrate the power of long-term compound growth in stocks relative to other asset classes. On it, the TSX Composite and S&P 500 clearly lead the way in terms of growth. So, why do we need to invest in something active that owns the stocks within those indices instead of just owning the indices to get that growth? Why take a chance that active management will outperform enough to make up for their additional costs?
Skewness of stock performance
In 2017 Hendrik Bessembinder, finance professor at Arizona State University, did a study comparing stock returns to those of treasury bills, in his paper titled Do Stocks Outperform Treasury Bills? In it, he consulted the Center for Research in Securities Prices (CRSP) database, which contains data for the stocks of over 25,300 companies since 1926.
His research revealed some interesting stats, including that the median life of a stock over the period from 1926 to 2016 was just 7.5 years and that if you randomly chose one stock and just switched it randomly every month, you underperformed 1-month t-bills 73% of the time.
The most eye-opening revelation from his study though was just how top-heavy, in other words concentrated in few companies, long-term wealth creation of stocks is. We all know that from 1926 to 2016 stocks as a whole significantly outperformed t-bills. There was no S&P yet in 1926, but going by the total return of the Dow Jones (not a real index, but a simple arithmetic average of 30 companies that takes into account splits), with dividends reinvested, you would have had a 9.76% annualized return over those 9 decades. I don’t even need to look up what t-bills did, as I’m sure it was less than half that.
Over that span, Bessembinder calculates that over $35 trillion of excess shareholder value (above and beyond t-bills) was created, which includes dividend payouts and (from my understanding of the study) subtracts for net share issuance. 10% of that wealth creation though came from only 5 companies: Exxon Mobil, Apple, Microsoft, IBM, and General Electric (as of 2016; GE might have fallen out of the top-5 now).
Expand the list to the top 90 companies, or 0.3% of all companies, and those 90 account for fully half of all excess wealth creation.
You only need to expand the list of companies to the top 4% to account for fully 100% of all excess wealth created over that time period. In other words, 4% of all U.S. stocks that existed from 1926 to 2016 accounted for ALL of the excess return stocks made above and beyond t-bills. If you didn’t hold any of those stocks, instead holding the other 96%, you matched or underperformed 30-day t-bills.
Why am I going on about this study? I guess the moral of the story is we have no way of knowing in advance which companies will be in the 4% when selecting stocks. Would you have known to put a healthy weighting into Microsoft back in the 1980s, to hold on to your decimated Apple shares throughout the early-2000s, or to get into Amazon in the late-90s and stay in them even after they lost 90% of their value? Would you have known in 1933 that a newly merged company selling punch-card machines, meat scales, and cheese slicers, called “International Business Machines”, would become one of the biggest creators of shareholder wealth over the next 8 decades? If only we had a time machine…
The only way we can be assured of having those important 4 percenters in our portfolio is through indexing. We can take a chance picking stocks ourselves, but then we run the risk--a strong probability--of owning only the 96%. We can put our trust in an active portfolio manager, but even they will likely miss most of the stocks that will drive most of the wealth creation for the next 90 years, or at least won't get in them early enough.
There have been numerous studies done that compared the stock-picking acumen of professionals (not even retail investors, but professionals with decades of experience) with monkeys, lab rats, even a house cat. In today's very efficient markets your odds of picking the 4% "winning" stocks are about as great as picking next year's Stanley Cup finalists.
Chief technical analyst notes that trend line is still acting as overhead resistance pic.twitter.com/L25tgvMrA1— StockCats (@StockCats) July 31, 2019
Plain and simple, indexing is the least risky way to ensure we get a benchmark return, in a portfolio containing all of the 4% stocks (albeit small allocations) that will neither outperform nor--more importantly--woefully underperform it. Further, the broader the stock index in terms of number of constituents, the better, which is why I use a total market index ETF as the core U.S. holding in my Elementum portfolios.
Reliability of index funds
I’m kind of an armchair portfolio theorist. I’ll never write any peer-reviewed papers, like Professor Bessembinder, nor win a Nobel Prize, like Eugene French & Kenneth Fama; I’m not that smart. I spend my days doing financial plans for clients, occasionally steering them through turbulent markets, and building or tweaking easy to understand and low-cost portfolios for them.
I do have a good grasp on modern portfolio theory, the efficient frontier, and how when we mix a bunch of assets with low or negative correlations with one another we get a portfolio whose return will be the weighted average of those assets, but whose volatility will be quite a bit less than the mean average.
In order to build a portfolio and get an idea (we can never really truly predict…) of what future risk and return might be, it’s nice to have many decades of past history on those asset classes. We don’t have decades of history on most actively managed mutual funds nor on stock picking strategies. Maybe, at best, we know how a strategy did through 2008 and the recovery, but do we know how that strategy did during the stagflationary period of the late-1970s?
We know that indexing works. From when John Bogle introduced the first S&P 500 index fund in 1974 to present, it performed more or less in line with the index minus fees and a minuscule tracking error. So we know it works for other stock indices as well. If those indices go back 50 or even 100 years, we know that a portfolio tracking them today can reliably expose us to the same risk and return. Why do anything but index?
I’m coming off sounding a lot like John Bogle in this post. Actually, a good intro to investing book I can recommend is his Little Book of Common Sense Investing, where you can read much the same messaging.
Truthfully, in my own portfolio management I do utilize some active management here and there in order to get exposure to some asset classes that are a bit more difficult to invest in via index ETFs or to get exposure to an investing style which itself has a low correlation with the indices (in other words NOT closet-indexers!).
I will say though that EVERYONE investing on their own, without the same ability to do their own thorough research and due diligence on an active manager, should be investing exclusively in index funds. The simpler and lower cost, the better. The risk of ending up with a return well below the benchmark, using an active manager or stock-picking on your own, is far too great and I think even more of a concern than the additional costs of active management.
I’m more than happy to review anyone’s portfolio, who contacts me, and let you know if you’re on the right track or could be doing something better. Heck, you can probably tell by reading the above that I consider it one of the funner parts of my job, armchair finance nerd that I am.
Markus Muhs CFP, CIM
Investment Advisor & Portfolio Manager