Confessions of an Investing Parasite

As index investing has gained popularity, it is also attracted its share of scorn. The latest example is an unintentionally amusing blog post called Index funds are parasites and are going to kill the market, which appeared last week on the UK site Stockopedia.

“In a way, index investing is the ultimate piggyback ride on the coattails of the active management community,” the author writes. Even if you ignore the mixed metaphor, that’s a provocative statement. He later adds: “If there were any justice index funds would pay a tax to the active management community for their service.”

I’m not even sure where to begin a rebuttal of this kind of nonsense. Perhaps we should start with the rich irony of suggesting that retail investors are victimizing “the active management community.” Many active managers are excellent stewards of their clients’ money, and they deliver good results at a reasonable cost. But they’re not Gandhi. They’re in the game to outsmart those on the other end of their trades, and to profit from the mistakes of competitors. Yes, active traders are the reason markets are largely efficient, and in that sense index investors do benefit. But this a by-product of the activity, not its intended goal. To imply that they are providing some sort of public service is absurd.

Get out of the game

In The Arithmetic of Active Management, Nobel laureate William Sharpe explains that for every invested dollar that outperforms the market, another dollar must underperform. Once you factor in costs, that zero-sum game becomes a loser’s game, where only a small number of competitors will earn outsized returns. And when you’re invited to join a game with a low probability of success, the rational decision is not to play.

Larry Swedroe uses a clever analogy to explain this point. He asks you to imagine being a basketball player who successfully makes free throws 80% of the time. Assume the best free-throw shooters are successful 90% of the time, while the average player shoots 65%. The league is holding a competition where players are invited to attempt 100 shots and receive $100 for each basket. You are given a choice to enter the contest or simply accept the average payout of all those who participate. Which do you choose?

Your percentage is significantly better than the average player, so you probably think you should enter the competition. But as Swedroe points out, it’s likely that all the below-average players will opt out. Indeed, only the very best players should choose to enter the competition, and if that happens the average score will not be 65%: it will be around 90%. So even as an 80% shooter, you are better off not playing the game and simply accepting the average payout of $9,000.

I’m more than happy to admit I’m a below-average stock picker, and I certainly have no hope of outsmarting the best active managers. So I choose not to play the game, and to simply accept market returns at low cost. This is not parasitic behaviour: index investors are not free riders. We assume the same risks as any other market participants.

When I go to bed tonight, I will say a humble prayer of thanks to the active management community for providing the public such an efficient market. But my sleep will be unburdened by guilt for riding their coattails.

23 Responses to Confessions of an Investing Parasite

  1. Michael James March 22, 2013 at 1:45 pm #

    Well said. I see an analogy to poker. Six or seven years ago, there were a lot of bad Hold ‘Em players around. I didn’t play a whole lot, but I used to be able to make about $20/hour, on average, playing $1-$2 no-limit. Now I can’t. The average player in Vegas seems to be getting better, and there seem to be fewer players. I suspect this is because the worst payers stopped playing and the rest are improving. In this case, indexing is analogous to just not playing poker. Apparently, I should think of everyone who doesn’t play poker as a free rider messing up my ability to take money from fools.

  2. Canadian Couch Potato March 22, 2013 at 2:04 pm #

    @Mike: I found the same thing. When TV poker was first becoming popular, it was very easy to win money from the “fish.” But even if you play low stakes tables online today the quality of the play is quite good: I gave it up a few years ago for the same reason. The parallel with Swedroe’s free throw contest is almost perfect.

  3. Galactus March 22, 2013 at 2:04 pm #

    Calling passive investors “parasites” is obviously stupid, but there are some interesting points in the article. For example: ” the stock market has only a finite capacity to absorb passive investment funds without materially and detrimentally impacting the market”. This seems obvious to me, if everyone starts just following an index, it would kill rational investment and create a lot of distortion.

  4. Canadian Couch Potato March 22, 2013 at 2:14 pm #

    @Galactus: I think we need to extend that argument further. If too much indexing led to price distortions, it should follow that active managers should be able to exploit those mispricings. Soon more and more people would stop indexing and try to gain an upper hand by active investing. That in turn would cause the mispricings to disappear (as is the case with any other market inefficiency). Somewhere there must be an equilibrium: I don’t know where that is, but it would only take a small number of active managers to maintain market efficiency.

    This is not a new idea: there have been many papers looking at these ideas. This one from Vanguard is interesting:
    https://personal.vanguard.com/pdf/s300.pdf

  5. Value Indexer March 22, 2013 at 2:56 pm #

    Both sides benefit each other. Thanks to active investors, index investors can buy value stocks cheaply and sell quality stocks at a good price (as part of the index of course). And thanks to index investors, active managers have a willing and ever-present trading counterpart instead of trying to fool someone who may be smarter than them.

    To use an example from someone who was promoting active trading it’s like a grocery store. The merchant finds and buys cans of beans at a low price and then resells them to consumers who will (within limits) buy at whatever price is offered. Everyone benefit from this and we need a lot more consumers than merchants to make it work.

    In addition, indexing seems to be one of the investing strategies that is self-evident rather than self-defeating. If lots of people are buying into indexes that may reduce the future returns, but it is still better than the alternatives. It’s similar to a simple mechanical rule such as only buying stocks with dividend yields over 5% and a payout ratio under 50%. If everyone did this it would get harder to find opportunities, but strictly following that rule would still keep you away from many bad investments.

  6. Andrew March 22, 2013 at 6:51 pm #

    Interesting post and comments.
    I think the parasite comment derives from a worry in financial services – savers and investors are starting to do some math – with lower potential returns from bonds, a general conservative positioning because of demographics, fallout from the financial crisis and debt deleveraging – people are questioning the math on real returns after fees.

    I was reading this paper yesterday about the Norway Fund
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1936806

    In it are the returns for 10 years to June 2011:
    Gross Return: 4.59%
    minus Price inflation of 2.16%
    minus Management costs of 0.11% = 1.55% Net Real Return
    Standard Deviation 10.50

    One of the reasons the fund is cited as a good example is because it indexes and rebalances and because it has such low fees.

    Do the math again with your standard 1.5% fee and your net real return is 0.1%!

  7. Mike March 22, 2013 at 9:54 pm #

    Great post. I would like to know your opinion, however, about whether there is a place in a portfolio for inexpensive and well run-actively managed funds. I am currently weighing what to do with a sizable LIRA payment that has come my way. While I have most of my current portfolio in ETF’s, the Mawer Balanced fund looks very attractive. Do you have any thoughts?

  8. Canadian Couch Potato March 22, 2013 at 10:23 pm #

    @Mike: I would never argue with someone who wanted to keep some of their portfolio in a low-cost, prudently managed fund from Mawer, or Steadyhand, or the like. Same with someone who felt strongly about holding some individual stocks for whatever reason. I’m not sure it will add much value in the long run but it’s unlikely to do any harm either.

    http://canadiancouchpotato.com/2011/06/27/cant-we-all-just-get-along/

  9. Smithson March 23, 2013 at 10:43 am #

    @CCP: Thanks for the link to the article on the “parasitic” nature of index investing. It was very amusing. I found the speculation about the implications of index investing overwhelming active investing particularly funny. I worry about a lot of things in life, but one thing I don’t worry about is the scenario where everyone becomes indexers. The reason for this is simple – the human capacity for overconfidence is infinite.

    Here’s a good example. I work in the scientific area. For most of the people in my field, math is a second language. One of my co-workers is a die-hard stock picker. He and I have had many discussions about the relative merits of passive and active investing. To prove that passive investing was the better approach, I sent him links and references to the academic research comparing passive and active. After he read the research, he came to me and admitted that I had made a compelling case and there was a higher probability of generating superior returns using a passive approach. Regardless, he wasn’t going to stop being a stock picker. I asked why. He said that he still believed that he could see inefficiencies in the market and that he could pick stocks better than the average investor. I was stunned. My co-worker is a smart guy with an advanced degree, but he wasn’t going to change his behaviour even after accepting the evidence in favour of passive investing. After this incident, I’ve concluded that active investing will never die since everyone believes that they are “smarter than the average bear” (with apologies to Yogi Bear).

  10. Canadian Couch Potato March 23, 2013 at 1:06 pm #

    @Smithson: Great story! I can’t say I’m surprised to hear that even mathematically or scientifically trained people fall prey to overconfidence in their own abilities. It is true that they are likely to be better stock pickers than average. The same is true of people specifically trained in finance, of course. But the Swedroe analogy makes it clear that it isn’t enough to be significantly better than average when you are competing against the super-elite.

    As Prof. Meir Statman wrote on this blog a couple of years ago: “I have a Ph.D. in business yet do not think that I have a leg up. Goldman Sachs has a leg up.”
    http://canadiancouchpotato.com/2011/01/12/what-investors-can-learn-from-entrepreneurs/

  11. Andrew March 23, 2013 at 1:33 pm #

    Mike
    My sister owns the Mawer fund in her RSP and I was thinking about it for one of ours. She is a GIC oriented person or just keeps things in a savings account so this was a way for her to get exposure to equities that I could convince her of. The reason is because it is set and forget, reduces complexity and overcomes inertia and behavioural biases to do things to the account, like rebalancing more frequently than necessary.

    There are a lot of balanced funds I wouldn’t touch however – I have done research on this and there is just a handful I would consider but Mawers is at the top of my list.

    There is only one thing to think about with a balanced fund, how much to put in each year, and there is one statement. As the balance grows however I think we would go to using ETFs because of the relative efficiency.

  12. Noel March 23, 2013 at 1:53 pm #

    That Stockopedia article was hilarious. The author has severely discounted the fact that emotion and sticking with a plan probably have more to do with successful investing than anything else. He writes:

    ‘In this respect, Joel Greenblatt’s latest book, “The big secret for the small investor” is a great eye-opener. It preaches that many would be better off investing in equally weighted or fundamentally weighted funds. But even better than this is to build your own portfolio around solid and sound investment principles. Greenblatt preaches a mantra that we at Stockopedia stand by, that you can beat these index funds by creating your own low cost systematic investment strategy and investing directly in the underlying shares. We are building the tools to do this and believe fundamentally that it’s a saner approach than the growing madness in much of the institutional money management world.’

    Sticking with passive index investing, ie determining and adjusting an asset allocation, investing regularly no matter what the market does, rebalancing and then possibly tax harvesting is tough enough for most people over the long term, never mind executing a plan where one identifies shares and invests directly in them. In fact, putting the focus on individual stocks increases the likelihood that one will second-guessing one’s self and starting to trade frequently in individual stocks as news about those stocks resonates in the newspaper, on the internet, on CNN, CNBC, etc. With index funds the focus is never on individual stocks and so news about them does not affect one’s behaviour as no stock has much influence on the behaviour of the index as a whole.

  13. HarveyM March 23, 2013 at 3:05 pm #

    Honest active mutual fund managers (unlike closet indexer ones) have the goal of “outperforming the market”. The explanation for their higher fees (even the cheapest are at least three times etf MERs) is the research involved in stock picking. I would buy active funds (even Mawer’s) under one condition: there needs to be truth in advertising and some backbone to their claim! If active managers outperform the market they should be properly reimbursed with higher fees yes, however, if they fail then they should reduce their fees accordingly in that year (because they failed) rather than blame the market! Why not? Active fund mangers need a backbone in my opinion for what it’s worth!

  14. dale@streetwise March 23, 2013 at 7:13 pm #

    last time i checked the equity indexes were the largest companies in any given country. nothing to do with the active managers? lol

  15. Death and Taxes March 23, 2013 at 10:44 pm #

    What I like about index investing is it allows a someone with a relatively small amount of funds to be balanced right from the first few trades. Following a 60/40 or 50/50 balance between equities and bond funds one can build right away and as more funds become available you can diversify further. Picking stocks on the other hand with little available cash flow can set one up for failure right from the first trade.

  16. Nathan March 24, 2013 at 6:34 pm #

    @HarveyM: Unfortunately, there’s a problem with even this approach. Say the manager makes a fairly large fee in years where the fund outperforms, and average one if it roughly tracks the market, and absolutely nothing in years when there is a loss. Rather than encouraging good stewardship, this would simply encourage extreme risk-taking. Either the risks will pay off big for a payday, or they won’t. Probably almost half the time the manager will outperform, and so on average will earn good money. The fund though, not so much. (Active managers who try to Do The Right Thing would end up earning less, since net of expenses they will generally trail the market.)

    For performance-based compensation to work, fund managers would actually have to pay money out of pocket when the fund took a loss, which obviously not many would be willing to do! (And even then, the active managers wouldn’t be able to beat the laws of mathematics, so it’s not like they could make their funds outperform just by trying really hard. :) )

  17. Nathan March 24, 2013 at 6:39 pm #

    @dale: can you explain your comment? “last time i checked the equity indexes were the largest companies in any given country. nothing to do with the active managers? lol”

    Equity indexes aren’t companies at all; they’re indexes. Are you saying equity indexes HOLD the largest companies? Naturally that’s true. Or are you saying that large companies create indexes? Or operate index funds?

    What does the question, “Nothing to do with active managers?” mean? Indeed, indexes have little to do with active managers, although index funds do benefit from the relative market efficiency that active management brings about, as mentioned in the OP. Was that the question? I don’t see the joke though.

  18. HarveyM March 24, 2013 at 9:54 pm #

    @Nathan
    “For performance-based compensation to work, fund managers would actually have to pay money out of pocket when the fund took a loss, which obviously not many would be willing to do!”
    I agree. But there’s this chatter by some active fund managers regarding “not focused on tracking an index, but instead focused on making money in good markets and bad”. If active managers really believe their approach is a better one than simply “tracking an index” then I challenge them to show some backbone and realize a penalty when you fail to beat the index. Otherwise, it’s just slippery used car salesman words to entice the novice investor who would do way better with disciplined passive index investing for the long term.

  19. Death and Taxes March 25, 2013 at 12:46 am #

    Bottom line is as more people take control of their own DIY style and do well, these active fund managers are going to have to come up with a more innovative approach in order to give real value to the clients or go the way of the dinosaur..

  20. Shawn March 26, 2013 at 11:11 pm #

    @death
    That is a nice sentiment, but no, active managers are unlikely to need to ever pull up their socks. The masses (and people in general) are inherently lazy and greedy, meaning 2 things, they don’t save and when they finally do they will try to hit an investment home run. Despite the popularity of this blog and similar, folks like us are the minority and will continue to be. All the better for people like me (us couch potatoes)!

  21. Death and Taxes March 27, 2013 at 12:40 am #

    @Shawn
    Very true on all counts.
    Sadly for those that let greed get the better part of them for all their losses if they had just stuck to a little discipline by creating a well diversified balanced portfolio they would in the end have more than exceeded any gains (if any) of trying for that home run.
    As for the majority of lazy sheeple, they get what they pay for by being too disinterested to take the time to learn an effective DIY method.
    One thing I have found above all in educating myself. DIY is a hell of alot of FUN which makes it all the more easy to absorb!
    Good fortune to all the CCP out there!

Trackbacks/Pingbacks

  1. Weekend reading: Easter mindfulness - March 29, 2013

    [...] Confessions of a passive investing parasite – Canadian Couch Potato [...]

  2. Weekend reading: Easter mindfulness | Since 1996: expat-world.com means Offshore tax avoidance with protection - March 29, 2013

    [...] Confessions of a passive investing parasite – Canadian Couch Potato [...]

Leave a Reply