I received a call last week from a friend who used to actively help me invest my money. Because our skills were different, but complementary, we were actually able to help out each other quite a bit. Time moves on, circumstances change and we find ourselves not working together as before. As he was looking through some old records, he found a list of stocks I had owned when we were working together. To the best of my recollection, this list comprised of stocks I owned back in 2007.
During our call he noted the prices of these stocks I’d owned then and their prices now:
Stock Old Price Now Price Percent Change
“A” $33 $69 +109%
“B” $20 $25 +25%
“C” $12 $9 -25%
“D” $31 $39 +26%
“E” $47 $66 +35%
“F” $44 $57 +30%
“G” $58 $87 +50%
The average return for these stocks is around 35%, which sounds great by itself. The real kicker was when he mentioned the market’s return over the same period:
S&P 500 $1411 $1388 -1.6%
This last bit of information changed the returns from the stocks mentioned from “good” to “exceptional.” This simple exercise re-enforced a fundamental and critical idea which lies at the heart of all that I do as a professional investor – “You can beat the market!”
Too many people (in my opinion) have bought into the notion that the efficiency of markets precludes ANYONE from doing better than market returns. Support for this idea usually comes in the guise of aggregate returns for mutual funds. Yes, according to these data, the “average” return of all mutual funds can lag the market from time to time. There are a number of reasons for this (which are beyond the scope of today’s note), but nowhere do the data support the conclusion that NO ONE can ever beat the market. In fact, these studies show that nearly half of the funds measured beat the market in any given year.
“But”, the skeptic may say, “can anyone beat the market consistently?” Here too, the data seems to lead one to this conclusion. The trouble is that most studies will look only at annual or quarterly returns. I will readily admit that it is nigh to impossible to beat the market each and every quarter and year. If one is suggesting that “beating the market” means only to outperform it each and every year, then, yes, no one can do that. But, if it means to have above-market returns for a long period of time, then many, many people do this on a regular basis.
Bill Miller, who worked at Legg Mason, had an epic record of beating the S&P 500 for 15 years in a row. Many other mutual fund managers and hedge fund managers have 5-, 10- and 15-year records well above the markets’ return. Saying that NO ONE can beat the market because the AVERAGE mutual fund doesn’t, is like saying no one can make it into Harvard, because the average applicant doesn’t.
So why would anyone want to invest in an index fund that is designed to provide market returns? First of all, it seems easy. Stock picking is hard work and not everyone has the time, skill or energy to do it. Buying an index fund allows one market exposure without having to worry about individual stock selection.
Second, it can be a more inexpensive way to invest. Index funds usually have lower fees than mutual funds. An actively managed portfolio, whether it’s a mutual fund or a group of individual stocks, may have higher fees and commissions attached to it.
Third, it seems less risky. Here is where the water gets a bit muddy. True, owning an index fund is less mathematically risky than owning one or two stocks, but it may not be less risky than owning a mutual fund or a well-diversified portfolio of individual stocks. This is simple math. In the case of my stocks from 2007, owning the market was the more “risky” option.
So what’s wrong with index investing? In my view, it guarantees that you will not beat the market. It locks one into a return no better than the broad average. In a decade like the 1990s, this would have been fine. For the last ten years, much less fine.
Also, the way an index fund is managed assures that it will constantly buy high and sell low. That is, it will always be buying more of the stocks which do well (and have become a larger part of the index) and selling some of the stocks which underperform. To the value investor (like me) this seems exactly wrong.
Now a lot of smart people invest in index funds. And another bunch of smart people spend millions of ad dollars each year trying to convince the public that index investing is the “best” way to do it. It may be well beyond my power to “prove” that index investing isn’t a good way to invest, but I am pretty sure that it’s not the best way for EVERYONE to invest.
I don’t do it. My clients don’t do it. And maybe, just maybe, everyone who is doing it should make sure they’re doing it for all the right reasons.











