One of my general “life rules” is that anything, whether inherently good, bad or indifferent, usually becomes bad if taken to the extreme. For example, if a glass of wine at dinner can aid digestion (something some experts will attest to), then a bottle (or two) at dinner should really help out, right? If exercising three times a week for 30 minutes each is good for one’s health, then working out 7 times a week for 3 hours each day is even better, right? You get the picture.
This concept also raises its ugly head in the investment field from time to time. Take diversification, for example. If owning 30 stocks is a good way to reduce non-systematic risk (that is, the risk associated with one stock), then owning 50, 100 or even 300 would be better, right? Well, the studies I’ve seen suggest the opposite. A portfolio of 30 stocks (assuming the holdings are intelligently spread out across different sectors) can be optimally diversified. Adding even one more stock, according to the smart guys who measure this stuff, does very little to aid diversification.
Indexing may be another example of this. Indexing is simply the idea of “buying the market” via funds which by design are supposed to mimic some underlying index such as the S&P 500 or the Dow Jones Industrial Average. Indexing, at its genesis, was a simple concept, allowing investors who were happy with just market returns to achieve them. The conceit here was that “beating the market” was something better left to the professional investors. Indexing made sense for the average person who lacks the time, resources, training, discipline and perhaps inclination to work hard enough to beat the market. Easy stuff. So far so good.
At some point, the people who were in charge of marketing index funds (after all, most financial products are sold, not bought…) began using some very impressive research reports produced by professors of finance at impressive universities which showed that index investing could produce returns better than some portion (half or more) of professional managers. To the mathematically inclined, this should be no surprise if the distribution of returns of mutual funds is a normal distribution, which it is. Additional research piled on suggesting that if one were adjust for taxes and fees, indexing looked even better.
This is about the point where something good (indexing) gets taken to the extreme and becomes bad. I will let Don Philips, President of Morningstar’s fund research, fill in the details.
He said, “At some point… index fans went from making the honest and helpful argument that indexing is good to making the hyperbolic and divisive case that anything other than indexing was not only bad, but also morally suspect. Extreme index supporters went from asserting that indexing beats the average fund to implying that it beats all funds…. Their words have grown more extreme, as seen in a recent statement from an ETF provider that likened active fund managers to big tobacco companies, claiming that active management was as dangerous to investor wealth as tobacco is to our health.”
My sense is that the index marketing guys have been very successful in convincing the public of this idea. Many people I speak with feel that “beating the market” is impossible and that indexing is the only way to invest. To me this idea is ridiculous. There are very many professional managers who have beaten the market for many, many years. I’m not going to name names, but I could. Many of these fund managers are my heroes, my role models. I am trying to employ many of the same investment tactics, strategies and philosophies which they use. Can I beat the market? For many reasons (including some compliance ones), I must demur on this question. But I can say without equivocation that I am trying to beat the market every year. I believe it can be done.
Let me offer one final point which supports my belief. In one of the egghead journals (those that use formulas!) which I read regularly, a study looked at aggregate returns produced by the hedge fund industry over a 14 year period. This study showed that the hedge fund industry, in total, produced excess returns (alpha) in every single year from 1994 to 2008. Said another way, the hedge industry as a whole, beat the market every year, regardless of the direction of the market. The market can be beaten by a lot of people, a lot of the time.
So far, I have not seen an adequate response to this revelation from the index people.