Another Weak Criticism of Indexing

August 23, 2012

The investment industry has never been kind to index investing, but the criticisms are getting weaker and more desperate.

An article in yesterday’s Globe and Mail gets off to a bad start by suggesting the recent growth in indexing is the result of a marketing campaign: “The financial firms want you to buy the index because they’ve figured out that they can make a good buck selling index-linked products—funds and especially ETFs.”

I suppose it’s true that investment firms like BlackRock and Vanguard want you to buy their products. But the growing popularity of index funds and ETFs has largely been the result of the appalling record of active management, and it has come despite the best efforts of the financial industry, not because of it.

No doubt a small number of firms are “making a good buck” from index funds, but ETF assets in Canada are still about $50 billion, compared with about $800 billion in mutual funds, the vast majority of which are actively managed. That’s about a 6% market share. To suggest the fund industry stands to profit from more passive investing is like arguing the fast food industry is organizing a conspiracy to promote salad.

Staggering costs?

The writer concedes that ETFs have low management fees, but then argues that’s only part of the price tag: “The cost of owning a broad index, particularly the TSX’s, is well hidden but staggering.” The key point, he explains with the help of a Montreal fund manager, is that companies in large-cap indexes like the S&P/TSX 60 are selected mainly because of their size and liquidity. “There’s scant attention paid to the company’s fundamentals, which could be poor or non-existent.” Another problem, the fund manager says, “is that the index is also full of companies that are always looking for new money. Banks, oil and gas, mining—all chronic issuers of capital.”

I have no argument with one of the main points in the article. While most investors value liquidity (the ability to buy or sell an asset easily, with low transaction costs), it does come with a price. Academics agree there is a liquidity premium in the equity markets: you pay extra for the privilege of owning an asset that is easy to sell. That’s one of the reasons small-cap stocks, which can be highly illiquid, have higher expected returns, albeit with higher risk. So when the fund manager says you can improve returns by tilting to smaller companies, he’s right so far as it goes. But it doesn’t go very far.

In with the good, out with the bad

The rest of the article describes how the manager “has trounced the index since 2006,” in part because he runs a relatively small and nimble fund that isn’t bound to an index. We’re told he “invested heavily in Telus Corp. and BCE Inc.,” which earned him “outsized returns” but barely benefited index investors, since these companies make up only a small part of the benchmark. That’s all we’re told about the investment strategy at work here: buy good companies, not bad ones.

At least this is consistent with the author’s April article, which explained that the top 50 companies in the S&P/TSX Composite (which includes over 250 stocks) beat the index handily. Therefore, if you are able “to find the roughly one in five companies whose shares will do well” you can outperform an index fund. And how do you identify those winners? “It takes hard work, skill and common sense.” To hear anything more specific, you have to subscribe to the author’s $200-a-year newsletter.

It’s unfortunate that this passes for debate. There is no data, no research, just a flimsy argument that sounds compelling until you scratch the surface. Index investing is flawed because you get bad companies as well as good ones. It’s possible to beat the market: here’s one guy who did it. Is anyone really swayed by this?

The unanswered questions

If picking winners is so easy, why did 97.3% of Canadian equity manages underperform their benchmarks over the five years ending in 2011? And why, despite the “staggering” costs of large-cap index funds, did the iShares S&P/TSX 60 (XIU) return 8.38% annually over the last 10 years, compared with an average of 5.88% for its actively managed peers? (Figures are from Globefund as of July 31.) Surely this dreadful track record can’t be explained away by saying that fund managers are constrained by liquidity. Might another reason be that picking stocks according to company fundamentals isn’t nearly as easy as it sounds? Or perhaps that XIU’s fee is 10 or 15 times lower than that charged by most money managers?

Indexes and the funds they track are not perfect, and I keep an open mind when it comes to well-reasoned criticism of the strategy and the products. But if you’re going to take on the mountain of evidence that supports indexing, you’re going to have to do better than red herrings and vague anecdotes.

{ 31 comments… read them below or add one }

Kiyo August 23, 2012 at 8:26 am

I read this yesterday and almost posted a link to in you the comments for your last post… in case you missed it.

Take heart: the reader comments in the Globe did a pretty thorough job of blasting the piece.

Lawgman August 23, 2012 at 9:47 am

I think the other strategy referred to in the article was investing in small cap and mid cap companies which is something the author claims the index does not capture. I guess the author never heard of your Uber Tuber portfolio or the fact that there is a small cap index and a mid cap index and related ETFs which can be used to build a complete portfolio. Of course there are also total stock market etfs which include more investments than just large cap.

Canadian Couch Potato August 23, 2012 at 10:08 am

@Lawgman: Good points. There is an index fund that can give you access to virtually any asset class you want. The Globe article, at its core, is simply an argument that picking individual companies is likely to produce better returns, but the only supporting evidence is an anecdote about one manager and two of his picks.

Philippe V. August 23, 2012 at 10:23 am

These (self-serving) arguments from active managers are indeed misleading and (to me) annoying. It is good that you remind us of the fundamentals and keep it more fact based.

While we are on the subject, I have been reading recently a few articles, in mainstream media, about how some active managers “outperform” using the economic cycle to position themselves in asset classes. For example before a recession, buy bonds since interest rates will go up -as if it were that easy. What really annoyed me was the insinuation of how markets are now more complex and that you should let experts handled the investing for you.

While reading these articles I was almost wishing I could read your reply to debunk their arguments :)

Andrew F August 23, 2012 at 10:33 am

You can definitely smell the desperation from the fund manager community. And who could blame them. A lot of them are very soon to be on much reduced compensation packages or out of the industry altogether.

Canadian Couch Potato August 23, 2012 at 10:36 am

@Philippe: Tactical asset allocation, like security selection, is often presented as a way of improving returns. As you point out, it too has great intuitive appeal: just buy when things are cheap, anticipate cycles, etc. As if this were easy to do. The economy in the US is still struggling but stock market returns there have been outstanding lately. How many people made that call? And anyone who thinks they have insight into the direction of interest rates is deluded, as the last three years have demonstrated.

Yes, a lot of professionals are arguing that markets are more complex now, and you need their help to navigate them. I would argue that markets have always been complex. Most people probably do need professional help with their investments, but they don’t need people who think they’re smarter than the market.

Mike Holman August 23, 2012 at 10:39 am

I was shocked at how bad that article was, mainly because I usually like Fabrice’s columns. He’s a good writer and obviously smart. Not sure what happened with this stinker.

The thing that is missing from the “stock picking guru” universe is performance measurement. Anyone can give stock recommendations and then highlight the winners after the fact. What I would like to see is for pickers like Fabrice, Gordon Pape etc is to set up dummy funds which are managed based on their recommendations. The results of the fund could be compared to an appropriate benchmark and then we can see if their newsletters are worthwhile or not.

Canadian Couch Potato August 23, 2012 at 10:52 am

@Mike: I would like to see the same thing, but I think we both know that will never happen. However, there have been a few gurus who have set up ETFs based on their strategies. How about Harry Dent:
http://news.investors.com/article/621147/201208061755/harry-dent-tactical-etf-folds.htm

Or Dennis Gartman, who runs an ETF from Horizons. It was founded in March 2009, a marvelous time to start your fund, since many markets have almost doubled since then. His ETF launched at $10 and is today worth $7.85.
http://www.horizonsetfs.com/pub/en/etfs/?etf=HAG&tab=overview

Pat August 23, 2012 at 1:34 pm

Have to smile at the irony in the first sentence of Fabrice’s article. His own article is self-serving, and isn’t he (and his newsletter) and Mr. Takacsy (and his firm) part of the conventional financial industry “telling you what to do”? Great job as usual Dan presenting valid, meaningful and accurate analysis to rebut the usual misleading anti-indexing arguments from the financial industry.

Peter August 23, 2012 at 4:46 pm

When I read the Globe article, I honestly could not understand a single argument it was making because it was THAT vague and dumb. It’s a complete waste of an article. Period.

John August 24, 2012 at 5:19 am

Fabrice’s article was bad journalism. Shame on him ! And shame on the Globe and Mail for publishing it!For one thing, Farbice builds the case against ETFs on only once source. It is another example of how the ‘financial pages’ of some newspapers contain articles written by industry insiders whose work is not subjected to the usual editorial rigour applied to other journalism. No real journalist, for example, could get away with writing a controversial piece using just one source. But the G&M permitted Fabrice to do this. In my opinion, these insiders write their articles mainly to serve as a marketing tool for their company or industry. You’ll find this regularly in the G&M. Reader Beware!

TM @ Young and Thrifty August 24, 2012 at 8:38 am

Thank god you wrote about this buddy. I wanted so badly to rebuff this article but didn’t have the time, and if you don’t do it immediately it kind of loses the audience. The G and M has actually posted a few really questionable articles lately written by people in the financial industry who have a huge vested interest in decrying indexing. I had formerly thought they had better editors, but I’m not so sure anymore. Anyway, thank you very much for fighting the good fight, and showing everyone how ridiculously flawed the argument was.

The Dividend Ninja August 24, 2012 at 11:55 am

Dan, I saw this G&M article yesterday and was going to fire off the link to you. I’m glad you wrote a rebuttal. This G&M article by Fabrice Taylor was completely ridiculous, and any investor would recognize that (whether the focus be on indexing or dividends).

It’s well proven that an indexed portfolio is one of the cheapest on fees – where else can a beginning investor get a cheaper deal than TD e-series funds, or the low MER for XIU? It’s unfortunate that the G&M has notched down its quality and credibility with articles like these.

Cheers
The Dividend Ninja

Jon Evan August 24, 2012 at 12:26 pm

G&M is just stirring the pot. Controversy sells and this article does just that! Nothing to do with reality just a means to create more heat for the dog days of summer crowd and increase readership. Nothing more.

Doug Cronk August 24, 2012 at 1:27 pm

I simply don’t see how the average Individual Investor can be expected to focus on Asset Allocation, Rebalancing, Costs, Taxes … AND … Active Manager or Security selection. Institutions can barely pick the best managers. And the best win maybe 60% of the time. I’d rather see the average Individual index / use ETF’s and focus on asset mix. And maybe blend in an active manager or two for a specialty mandate (IF, the Individual has a process to select the one for their needs) and maybe top things off with their favourite stock.

Canadian Couch Potato August 24, 2012 at 1:54 pm

@Doug: That’s a very wise piece of advice form someone who sees this first hand, so thank you. Active stock selection is so often presented as something that just requires some plucky research and common sense. As you point out, even the pros fail much of the time (most of the time, in fact). Why is it so often presented as the single most important part of a person financial plan?

If you want to dabble in it after you’ve looked after the big picture, fine, but that’s as far as it should go.

Rob August 24, 2012 at 7:36 pm

“But the growing popularity of index funds and ETFs has largely been the result of the appalling record of active management, and it has come despite the best efforts of the financial industry, not because of it.”

Well said. I was driving along the highway the other day and saw a billboard for a local bank that basicially said, “Saving for retirement? Buy our mutual funds.” Ok not exactly that blunt, but that was the point. I think they are running scared, knowing that people are slowly coming around to the fact that they don’t have to pay 2%+ anymore in management fees. I was surprised at the number of people I work with who contribute to our great company RRSP matching but leave it in default mutual fund. :(

Karim August 24, 2012 at 10:59 pm

” I was surprised at the number of people I work with who contribute to our great company RRSP matching but leave it in default mutual fund. ”

@Rob,
Thank you very much for your comment because it forced me to examine my company’s RRSP plan through RBC. It turns out I was in two funds, one with an MER of 1.82 and another at 1.78. I just switched over online to index funds with the highest being 0.72. I’m sure I’ll be getting a phone call. :)

sageinvestors August 26, 2012 at 12:40 am

The whole ETF concept is very murky now with advent of products that are “actively” constructed to track indexes versus the traditional passive product. These ETF 2.0 products to me are no different than actively managed mutual funds that carry higher MER’s and consistently under-perform the market. I commented on this recently on my site http://www.sage-investors.com/Articles/ETFJumpShark.cfm . When viewed through this lens, Mr. Taylor’s article has some merit, because if you had the choice of putting your money in an actively managed mutual fund or ETF 2.0 product versus buying some individual companies that have demonstrated an ability to manage their capital efficiently, have clean balance sheets, and good durable competitive advantage in their industry and buying them when they are on sale and holding them for a long period of time, I think you could do so much more cheaply and efficiently with the latter strategy than other professionally managed products. There’s enough studies that show the underperformance of actively managed portfolios.

When I initially start working with clients, I try to gauge their level of commitment in investing. If they could not bother doing the research on individual companies but want to have exposure to stocks, then a portfolio of simple, vanilla, low MER ETF’s that passively track the major global indexes and are rebalanced 1-2 times/year will suffice and will likely outperform many of the “experts” who manage money. If they are willing to take the time to do the research and learn about the fundamentals of creating wealth as well as understanding the psychology of the market, they can be equally successful in buying individual companies.

Best
Twitter: @sageinvestors

Moneyman August 26, 2012 at 2:45 am

While you indexers are congratulating each other, remember that the key feature of stock picking is that it involves choice. It remains true that most stocks lose value over the medium term. By choosing an index (e.g S&P rather than LSE) you are making a choice – although not avery specific one. Moreover you are giving up on the attempt to find those shares which actually increase in value over time. I agree that any investment strategy should be based on evidence and the evidence for active management is generally poor. That doesn’t mean we should just give up and float up and down on the general market tide.

My Own Advisor August 26, 2012 at 12:38 pm

The G&M article was painful. Any good article has a decent thesis, backed up by facts and evidence to support the claim.

Indexes and the index investors that follow them, will never be perfect but they stand a much better chance than the majority of investors if they invest this way for the long-haul and stick to a balanced plan. To suggest anything else is foolish.

When are they (G&M) going to offer you a weekly column Dan?

Try not to beat your head too hard against any firm object when you read more articles like this.

Hope my comment finds you well, and you’re having a good summer!
Mark

Andrew F August 26, 2012 at 2:23 pm

Mr. Sage:

You are putting words in Fabrice’s mouth. He is not talking about ‘ETF 2.0′. He’s talking about vanilla passive index ETFs.

Do you have any evidence that clients who are willing to do research perform as well or better than an index fund despite/because of that willingness to research? In aggregate, active investors must underperform the index, net of fees and costs. Someone is going to be a sucker, and evidence suggests retail investors are well represented in those ranks.

Badcaleb August 26, 2012 at 3:58 pm

The fund manager also has an anti-index fund. Guess he’s got to drum up business somehow.

Canadian Couch Potato August 26, 2012 at 9:03 pm

@Mark: Thanks for the comment. All is well here. Will you be attending the PF blogger conference in September? Would be great to finally meet you.

@Sage: I was going to add a comment similar to Andrew’s. Mr. Taylor’s article makes no mention of active ETFs: it was specifically a criticism of index funds. Both you and Mr. Taylor seem to take for granted that indexing is for people who don’t have the time to be active stock pickers, but this is nonsense. as Doug Cronk confirms above,
most professional fail at this activity, and one can hardly say that’s because they don’t have the time or skill. Of course, some people will always outperform, and this may be due to skill rather than luck. But let’s get over the idea that if you just put in a little research you stand a good chance of outsmarting the market. You don’t.

Sage Investors August 27, 2012 at 2:39 pm

In my experience there are 2 camps of investors I’ve come across, one that is willing to take the time to commit to learning how to research the fundamentals of a business or the components of a mutual fund/ETF (and the associated MER’s) and another camp that just doesn’t have the time, the motivation to do the work and will either instil the services of a financial advisor to make those decisions and/or go the DIY route. It’s the first question I ask people. I have no issue with either camp. Everyone has different life circumstances. Everyone in this forum has committed to educating themselves and their followers to make better investment decisions. A lot of people simply don’t and that’s OK.

With respect to the comment that if you put in some time to research you stand a good chance of outsmarting the market, I believe if you are willing to take time to educate yourself about understanding what are the fundamentals that drive wealth creation and stock prices (the numbers and business side) AND understand the psychology of how the key players in the market behaves, I think you have a better shot of not outsmarting the market, but at least putting yourself in a position (which is no guarantee) to earn a long-term rate return for equities. As investors that’s the best we can expect realistically. The whole “beat the market” culture that is espoused on Bay/Wall St is full of it.

Yes, Mr. Taylor focuses on “index-linked” funds and vanilla ETF’s. My issue is that these same traditional vehicles are not necessarily passively investing in specific indexes and are adopting very active management processes and use of derivative tools to build these portfolios which carry a higher cost, a higher tracking error and to a person who is not willing to invest the time and blindly do what a financial adviser and/or bank sales person tells them, that is a losing game. These same vanilla ETF’s are more and more morphing into closet mutual funds but are still being marketed as vanilla. That to me is a huge red flag and makes me more motivated to educate people on the importance of really understanding what you are investing in. In this time where people are truly scared to invest, it’s easy to fall into this trap. I’m not expecting the financial services industry to volunteer to educate its customers on the minutiae of its products, so it’s up to good people like this forum to fill the void.

So when you look at it from the perspective of investing in actively managed/closet mutual fund ETF’s versus applying a strategy of selecting a diverse basket of high quality, well-run, well managed companies with strong balance sheets that manage capital efficiently and consistently over a long period and buying them when they’re on sale, I would consider the later to not necessarily “beat the market” (because nobody can) but at the very least put yourself in a position to earn a long-term return commensurate with equities which for me is realistically 6%. The other option which is just as effective and endorsed within this forum, of buying pure, passive ETF’s that mirror major global indexes and carry a low MER and rebalancing 1-2 times/year is equally a prudent approach. Just make sure you’re those vanilla ETF’s are truly vanilla :)

Best:
Twitter: @sageinvestors

dale August 27, 2012 at 8:28 pm

thing is you’re no further ahead with an advisor and etf’s. they have to charge you 1% plus. the only ones who best the system are DYI ers. And we’re a small group. advisor fees and etf’s equal a mutual fund. Most r still better off in a mutual fund with reasonable fees. it takes only a small amount of research to find them. that said some need the hand holding of an advisor.

jamie quinn August 27, 2012 at 9:10 pm

It’s a bit off topic but I’m grabbing a phrase from your concluding remarks–”I keep an open mind”. What is your opinion of the active/passive appoach of etf’s like Wisdom Trees screening for dividend history and payout. A book like ‘The Single Best Investment’ comes to mind. Remind me why I can’t have my cake and eat it too.
And thanks for this great website.
Jamie

Canadian Couch Potato August 27, 2012 at 9:24 pm

@Jamie: Thanks for the comment. There are actually two quite different questions here. The first is whether dividend-focused ETFs can outperform, and the second is whether picking individual stocks based on dividends can do the same. I think the record of the WisdomTree ETFs speaks for itself: it’s pretty mixed. Some of their funds have done very well, while others have lagged significantly. I don’t think a dividend-weighted index is a bad idea, but the added costs and higher turnover will inevitably be a drag on returns. I’m agnostic about whether it will be a winning strategy over the very long term, and I wouldn’t argue too strenuously with anyone who wanted to adopt it.

Lowell’s book is quite different, in that he recommends picking individual stocks rather than using broadly diversified ETFs, I have far less confidence in the ability of amateur investors to build market-beating portfolios over the long term.

Mike Holman August 27, 2012 at 9:41 pm

With respect to the comment that if you put in some time to research you stand a good chance of outsmarting the market, I believe if you are willing to take time to educate yourself about understanding what are the fundamentals that drive wealth creation and stock prices (the numbers and business side) AND understand the psychology of how the key players in the market behaves, I think you have a better shot of not outsmarting the market, but at least putting yourself in a position (which is no guarantee) to earn a long-term rate return for equities. As investors that’s the best we can expect realistically. The whole “beat the market” culture that is espoused on Bay/Wall St is full of it.

Aman, I don’t understand how this paragraph helps your argument. Are you saying that someone picking individual stocks is not likely to beat the market? If that’s true, then wouldn’t a broad-based index product be a lot easier than picking stocks if it gets the same result?

Andrew F August 27, 2012 at 9:56 pm

Mr Sage,

You said:

“These same vanilla ETF’s are more and more morphing into closet mutual funds but are still being marketed as vanilla. ”

Do you have any evidence to support this? In particular, which vanilla passive ETFs morphed into ‘closet murual funds’. There are certainly new ETFs out there of dubious utility, but I’m not aware of any ETFs that changed their mandate from passive to active, or something that could be construed as active.

Sage Investors August 29, 2012 at 8:02 am

Valid points all around. I have a few points to share and an example of one company but alas the site is not letting me post them (but you can read this so hmm…). So I’ll try to end with this.

I’m not trying to bash the whole ETF concept. I like them. I use them. The reality is that the game has changed and there’s more marketing and spin around them now. They are not as simple as they used to be and so investors need to be aware of this and ask questions and dig into the details. This site is doing a great job of looking under the hood and calling the vendors out. I guess I’m just more old school in that the best value for money for me is the traditional vanilla brand ETF. Simplicity always wins with me.

Whatever option you choose depends on how confident you are in your analytical abilities, how disciplined you are in staying true to your strategy, your financial literacy, the time you have to research, and your tolerance for risk. Everyone is different. That’s why I love my work because every person I work with is different and their strategy to being a better investor is not a one-size-fits-all.

Best
Twitter: @sageinvestors

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