Image credit: “The Alchemist,” engraving, Pieter van der Borcht the Elder and Philips Galle, after Pieter Breugel the Elder, ca. 1558-1608, Rijksmuseum, Amsterdam
By Jason Zweig
12:22 pm ET Apr. 3, 2015
My Intelligent Investor column this weekend looks at the question of whether the rush of money into index funds could undermine the efficiency of markets.
Several value investors, who believe in the superiority of seeking to buy cheap stocks, have recently told me that the father of modern security analysis, Benjamin Graham, would never have endorsed the kind of “know-nothing investing” personified by index funds.
After all, someone who buys an index fund renounces all pretense of knowing which securities are cheaper or more expensive than others—or even which fund managers might be able to know that. And Graham was all about patiently, meticulously developing independent analysis in a long-term perspective, uncontaminated by the ever-shifting moods of the market.
“Index funds would have been anathema to Graham,” one value investor recently told me. Another asked how I, as the editor of Graham’s book The Intelligent Investor and the author of a column by the same name, could possibly endorse an idea so opposed to Graham’s beliefs.
The short answer: Benjamin Graham also believed in index funds, as his own statements show.
Born in 1894, Graham died in 1976, barely a year after John C. Bogle and Vanguard Group launched the first index fund for individual investors. But the idea for index funds had been on Graham’s mind for a long time.
In the 1951 edition of his great textbook Security Analysis, co-written with David Dodd, Graham discussed what he called “the cross-section approach,” or permanently owning a broad selection of stocks:
Stockholders as a whole must prosper or suffer with the rise and fall of corporations as a whole….An unabashed cross-section approach appears too simple to be sound, and it reduces the role of security analysis to a minimum. We suggest that the student should not dismiss it too contemptuously. It is by no means certain that the analyst will get better results from the type of selectivity most favored in Wall Street — viz., picking out the industries or individual companies that are likely to make the best comparative showing in the near future…. If we could assume that price of each of the leading issues already reflects the expectable developments of the next year or two, then a random selection should work out as well as one confined to those with the best near-term outlook.
In a speech he gave to a group of pension executives in June 1974, Graham said:
More and more institutions are likely to realize that they cannot expect better than market-average results from their equity portfolios unless they have the advantage of better-than-average financial and security analysis. Logically this should move some of the institutions toward accepting the S&P 500 results as the norm for expectable performance. In turn this might lead to using the S&P 500 or 425 lists as actual portfolios. If this proves true, clients may then find themselves questioning the standard fees most of them are paying financial institutions to handle these investments.
From a Q&A with Graham for a brokerage firm’s clients that was published in fall of 1976:
Q: Can the average manager of institutional funds obtain better results than the Dow Jones Industrial Average or the Standard & Poor’s Index over the years?
BG: No. In effect, that would mean that the stock market experts as a whole could best themselves—a logical contradiction.
Q: Do you think, therefore, that the average institutional client should be content with the DJIA results or the equivalent?
BG: Yes. Not only that, but I think they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisers and the like.
Q: What about the objection made against so-called index funds that different investors have different requirements?
BG: At bottom that is only a convenient cliché or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.
Graham liked to distinguish between two types of investors: “defensive” and “enterprising.” They were defined not by how aggressively they pursued risk, but rather by how much time and effort they were willing or able to put into investing. Defensive investors lack the inclination and interest to expend the energy it takes to try beating the market. The terms “defensive” and “enterprising” can apply equally to individual and professional investors.
James Grant, editor of Grant’s Interest Rate Observer, tells me that “Graham’s term ‘enterprising’ nicely captures what it takes to succeed as an active investor, especially the diligence and imagination that all too many professional investors can no longer afford to exhibit.”
For anyone who is an enterprising investor, analyzing individual stocks and bonds can still pay off. But for those who are defensive, index funds make perfect sense—as Benjamin Graham was among the first to point out, and as he never tired of saying.
Source: WSJ.com, Total Return blog