Posted by on Apr 6, 2015 in Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig | 11:44 am ET  Apr. 3, 2015

Have index funds become so popular that they are ruining the financial markets for everyone else?

These autopilot portfolios, which buy and hold essentially all the securities in a market index without even trying to find the best and avoid the worst, have become the giants of the market. Index funds accounted for 35% of total assets in all stock mutual funds and exchange-traded funds at the end of 2014, up from 25% in 2010, according to Empirical Research Partners, a firm in New York.

In the past five years, estimates the investment-research firm Morningstar, investors have pulled $73.6 billion out of “active” U.S. stock funds that seek to beat the market and added $208.8 billion to index funds that seek only to match it.

If investors keep turning their money over to machines that have no opinion about which stocks or bonds are better than others, why would anyone want to become a security analyst or portfolio manager? Who will set the prices of investments? What will stop all stocks and bonds from going up and down together? Who will have the judgment and courage to step in and buy during a crash or to sell during a mania?

Next week, James Grant, editor of the respected biweekly publication Grant’s Interest Rate Observer, and Vanguard Group founder John Bogle, godfather of the index fund, will square off in a debate on these questions at an investment conference in New York. One surprising thing they agree on: At this point, individual investors who pick their own stocks may stand at least as good a chance of outperforming the market as many professional investors do.

The triumph of the machines seems indisputable. Last year, according to S&P Dow Jones Indices, 87% of U.S. equity mutual funds run by active stock pickers underperformed the S&P Composite 1500 Index, a broad measure of the market. No matter which assets or time periods you measure, the numbers are still bad: Most of the active funds investing in bonds, real estate or international stocks also lagged behind their benchmarks over the past one, three, five and 10 years, S&P Dow Jones Indices found.

The superiority of indexing is on the verge of becoming “something very close to a secular religion,” Mr. Grant said in an interview. Financial history should teach us, he adds, that once everyone in the financial markets believes something to be obvious, it won’t last.

“There are no sure and easy paths to riches on Wall Street or anywhere else,” warned the great security analyst Benjamin Graham on the first page of his book The Intelligent Investor, after which this column is named. The popularity, ease and apparent certainty of indexing, says Mr. Grant, suggest that many of the investors who have rushed into it are bound to be disappointed. (See related post.)

“Most people simply don’t have the biological makeup to buy low, hold on and sell high,” he says. “There is an almost irresistible human urge to do the opposite.”

But indexing isn’t quite the unstoppable Goliath it might seem. Including the assets of such institutions as pension funds, insurance companies and university endowments, indexing accounts for 11.5% of the total value of the U.S. stock market, estimates Empirical Research Partners. That’s barely up from 9% a decade ago, largely because these big institutions have reduced their overall stockholdings in favor of such alternatives as hedge funds, private equity and real estate.

Until indexing becomes much larger, its ability to disrupt the market seems limited at best.

Mr. Bogle says the usefulness of index funds isn’t impaired by their popularity. “Owning the market cannot give you returns that are different from the market itself,” he says.

Both Mr. Grant and Mr. Bogle agree that the rising use of index funds isn’t to blame for the underperformance of active managers and that indexing won’t prevent markets from working properly. As Mr. Grant puts it, “the more people who are not doing fundamental research, the better for those who are doing it.”

The real culprit, both men say, is a lack of courage: Professional investors are afraid to be different, lest a rough patch of performance drive too many clients away.

Paul Isaac runs Arbiter Partners, an $800 million hedge fund that has earned 20.2% annually since it was launched 14 years ago, compared with 6.3% for the S&P 500. Along the way, says Mr. Isaac, the fund lost at least 30% three times. But because “a sizable portion” of its investors are “friends and personal connections of mine,” they stayed in the fund.

On the other hand, says Mr. Isaac, “if you’re investing on behalf of a critical mass of other people, then you have to manage the portfolio against the possibility that you might [lose so many clients] that it would impair the profitability of your business.”

As Howard Marks, chairman of Oaktree Capital Management of Los Angeles, which manages more than $90 billion, wrote last year: “Unconventional behavior is the only road to superior investment results, but it isn’t for everyone.” (If it were, then it wouldn’t be unconventional.) Added Mr. Marks: “In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes.”

So if you are considering an active fund, ask: How unconventional is this manager? Will his other clients tolerate it if he turns out to be temporarily wrong? And can he survive it if they don’t? Can you?

If you can’t get satisfactory answers, you could consider buying and holding a handful of stocks you meticulously research yourself—or just buy an index fund.



Source: The Wall Street Journal