Index Funds: Is Mine Really Better Than Yours?

The oddest thing about investing is the words used to describe the act of doing so. It seems to be an activity that revolves around the notion that somehow it can be described in such a way as to sway the average person to let their emotions do the deciding. I have over the course of a long writing career noticed the verbiage of investing has stayed more or less the same.

Most folks who do take a certain stance, do so religiously. Their fervor can be infectious. Their adamant belief can attract those who are somewhat unaware. And their use of certain go-to words often seemed designed to attract new investors who are already predisposed to agreement. Consider the investment is not gambling position of those believing in index funds.

Far too many people describe the idea of investing as not much more than a game. And when they extend the description of that game as one where you take chances, make bets or beat the odds as the way to achieve a positive result on your bet – and you do this using index funds – I immediately become sceptical.

Are these funds being oversold by the overzealous or are they really what they say they are?

Most people who have only a basic knowledge of what investing is might be able to tell you who¬†John Bogle, Charley Ellis or Burton Malkeil is. Anyone who knows index funds recognises those names and their affection for these market indexers can border on the fanatic, so much so that entering into any sort of discussion, such as this one, will no doubt elicit some sort of wrath. It is not my intention to poke the index fund industry. Nor is it my intention to dethrone their worship of these index heroes. I just thought I’d look at some of the contradictions.

Let’s talk about average. We are, from birth never told that we are not-so-special as compared to the kid next door. We are encouraged to be the best we can be, do all that is within our power to excel and the result from all of this effort is to be better-than-average. I have nothing against average. How would we we know what doing is better was without something to compare it to?

So it goes with investing. But what determines average? In the world of buying securities, index funds do.

They do so by suggesting that if you bought 500 companies, weighted them in some fashion that doesn’t necessarily reflect what any investor could mimic – few investors do what the most popular index type fund can do – you would have not much more than a benchmark. Weighting is something few indexers – this is something they enjoy calling themselves – can achieve without the help of a fund.

In fact, without the power of computing, all previous attempts at creating a viable and investable index failed until the mid-seventies. So to suggest it is simple is not close to accurate. If you can’t mimic it, it must be harder than we think it is – or told it is. Once created, it is suggested by those who formed this index, that because of its vast breadth and design, it be used as the benchmark for all investors to judge their net skill.

Failure to do so means that you have no skill or what you do have in the way of skill is somehow not much more than luck.

Yet indexers like to use gambling terms in their pitch to sway an investor from considering any other sort of investment for fear of losing. The “odds” are against you, they say and the “they” are the index funds. They set the odds and suggest that the probabilities are not in your favour if you use any other tool than index funds. And to a point, they might be right. Index funds do cost less than actively managed funds. Index funds are spread across numerous sectors offering a wide range of diversity, so as Rick Ferri who writes a blog for Forbes suggests, offer the world at the lowest possible cost – compared to actively managed funds.

But does he make a good comparison? Are actively managed funds, the ones that number 10 times as many index funds deserve such a bad name? Possibly and for two reasons. The first is their naked attempt to get you to invest with them. They need investors and they will do whatever they can possibly do to get you to look at them. They disdain average by embracing their boutique strategies, their hot-shot fund managers and their wildly original style. And some fail to attract the investors needed to keep them viable.

These are the failures, often absorbed into target date funds or other larger funds in the family.

Index funds, sort of like the mall comparing itself to an East Village shopping experience. use these come-and-go funds as the basis for what they suggest should have been the obvious choice all-along: passive investing. Yes these start-up cost more and yes, brokers can be blamed for pitching them to unsuspecting clients and yes again, they aren’t cheap. But investors are comfortable with the notion of perhaps, just maybe and potential, all beliefs understood by both parties.

It’s true, index funds do remove risk and costs giving the impression that “most people” are the ones seeking average. Yet indexers continue to taunt other investors who know a little bit about risk. They know that there is always a risk in investing and embrace that risk based on different degrees of acceptance.

They also know that the markets are somewhat of a gamble, even if the odds are lessened by spreading that risk out amongst hundreds of investments.

It is true that actively managed funds can lose more than index funds in the course of a market downturn.

They have fewer investments involved. But to index fund advocates, who see their enemies as the advisors in the brokerages, the argument comes down to this made recently by Mr. Ferri: “Indexing works because active investing can’t work.” I wonder if I had met Mr. Ferri in the schoolyard 40 some odd years ago would have made the argument that his dad could beat up mine?

Both types of funds can be used to the investors advantage. Both offer pluses and minuses, some emotional and some technical. Both have flaws that could be fixed and some folks to their credit are looking for ways. But it doesn’t boil down to who is better. It comes down to who can sleep better with their decision.

It’s a bet that we all make and a gamble we must engage in.

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