Expect Index Funds To Become More Popular

There is absolutely no doubt in an index investor’s head that those who chase actively managed funds are fools. Not the Motley type, because those guys think much the same about those types of fund investors as well.

But the sort of fools you suffer because you know they should know better, you know they are smart enough to do the maths and lastly, you think chasing average with a index fund entitles you to a degree of smug for know how inefficient the market is.

And that’s fine. An index investor is supremely confident that all will be well with their investment choice. The fact that they were able to purchase it for far less than what the actively invested mutual fund charges and that argument is always pointed out in every conversation about index funds makes the debate somewhat one-sided. Yes it is true that buying something for less is advantageous when it comes to investing. Low turnover (index funds readjust their holdings when the index they track changes) mean lower taxes (an interesting event because index funds sell losers and buy winners when they do readjust) and the combination of all of this seems to satisfy even the most average investor.

But I’m not so sure that actively managed mutual fund investors consider themselves average. Nor do they pursue such a state. In large part, because they already have it. As I mentioned earlier index fund investors like the concept of average. They embrace the inefficiencies in the market and defer the thinking about where the market will move next to the idea that spreading the risk is far more essential to protecting the underlying investment. But that protection comes with a cost.

If index funds are so much better for the investor than those of the active sort, why aren’t these the only investments in use? When you look at the differences in investment styles, you find that index fund investors tend to only own index funds whereas actively managed mutual fund investors own both.

Perhaps it is the very nature of index funds. Where in almost every instance, the traditional index fund is employed, the reality of how these funds allocate the money, with the 10 companies in the index usually garnering the top 20% of the indexed dollars might lead those active investors to think that there is a chance that the remaining 490 companies in a typical S&P 500 index might offer something of an opportunity.

Investing outside of index funds had been referred to investor ignorance. Betting against what are seemingly long odds of success has a certain attractiveness to the process. Call it the “what if” approach. Back in August of 2010, Lubos Pastor of the Chicago Booth School of Business and Roger Stambaugh of the Wharton School of Business wondered why do actively managed investors continue to chase these funds when the statistics offer evidence that the returns in these investments will be subpar.

To invest is to embrace the knowledge that in every investment there are two players: the one with the reason to sell and the one with the reason to buy. Trusting that a fund manager can determine which is the better side of that purchase is why actively managed funds remain more popular than index funds. True, few are skilled enough to find that pivot point but the professors have found that movement in and out of these funds, based on decreasing performance might have something to do with why they stay in these funds at all.

These investors, at least according to the professors take dispassionate rather than long look at where a fund is headed and readjust their investments accordingly. Nathan Hale of MoneyWatch believes that it instead “represents a fundamental misunderstanding of how investing works”. He argues that even though actively managed investors think the additional research they do, the faith in those that they have hired because of their expertise and the fact that they have to work harder to get the returns needed to keep investors investing, Mr. Hale writes that this will  “inevitably detract from the returns you earn in the markets”.

As long as the comparison of performance is skewed – benchmarks are always used when comparing the two types of investments when few if any actively managed funds hold 500 stocks in their portfolio – the proof of who is right depends on how fully you embrace the concept.

Active investors don’t suggest that indexing is wrong and may have been the result of an increase in net inflows to index funds over the last several years as they moved to protect some of their portfolios. They just believe that the opportunity to do better is worth the cost, adjusting their holdings to react to lack of or increased opportunity. Mr. Hale sees this shift as the embracing of index wisdom.

Is it a “recognition of the benefits of an indexed approach” as he suggests? Or is it perhaps the simple fact that using actively managed investments are more involved, intellectually stimulating and make the investor feel like an investor? Is it an understanding that to live as a investor (using every means possible) better than simply chasing average?

The use of index funds will increase as new investors come into the marketplace, uneducated or perhaps under-educated. Auto-enrollment may add to the involvement. The use of these funds by Baby Boomers looking for some equity allocation in the final years of their work-life, realising that some exposure is better than none may also contribute to the increased use of this passive investment. Time will tell. But actively managed mutual funds, even though maligned by index investors, will always be available to the investor.

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