Thursday, August 21, 2014

INDEX INVESTING: “YOU (DON’T) GOTTA HAVE HEART…”

8/21/14

The Wall Street Journal reports this morning (“Investors Pile Into Vanguard, Eschewing Stock Pickers”, page A1, 8/21/14) that investors are buying into index funds big time, driving Vanguard’s assets under management (“AUM”) to almost $3 trillion and making Vanguard’s Total Stock Market Index Fund the largest mutual fund in the world.  (A note is in order here; Vanguard, a firm that I advocate and highly respect is widely known as THE passive manager.  While it is the premier passive manager, and the virtual inventor of the index fund in practice, Vanguard has a big actively managed fund business, just about all of which is done through sub-advisors.  Further, you don’t have to invest with Vanguard to invest in passively managed index funds; most fund managers, even those, like Fidelity, who pride themselves in being great active managers, have substantial businesses running passive index funds.  Most of you knew that, but my readers span a wide range of financial sophistication, so I wanted to clarify that.)  Further, money flowing into index funds exceeded money flowing into actively managed funds by a factor of 6 last year and by a factor of over 2 this year.

Some of this influx has been attributed to something Warren Buffett, one of the few active (in his case, VERY active) managers who has beaten the indices over long periods of time, wrote in Berkshire Hathaway’s letter to investors in March.  He stated that he gave the following advice to the trustee of his estate:

“…put 10% of the cash in short term government bonds and 90% in a very low cost S&P 500 index fund.  (I suggest Vanguard.)”

Great minds apparently think alike (See below.); some just get to the party later than others, but getting there, not when they get there, is the key.  But I digress.

The world seems to have caught onto the argument, long advocated by yours truly (See, inter alia, EXOTIC INVESTMENT PRODUCTS FOR THE “AVERAGE GUY”:   WHAT’S THE POINT?, 8/16/13 and the posts to which it will refer you.), that index funds are the way to go.  Combine the inherent efficiency of the financial markets with the low cost and lack of manager risk of index funds and you are nearly sure to beat active managers over meaningful periods of time by investing in index funds.   Just about all my money is in index funds. 

(A point of digression here:  So why do I have any actively managed money?  That’s a long and not all that interesting story that I will save for another time.  For now, suffice to say that almost all of my non-index money is invested in funds that use screening techniques and thus eliminate, or at least minimize, manager risk, much like index funds, and keep costs reasonably low, though not as low as index funds.  I like to refer to them as “index-like” products and they play a limited role in my portfolio.  Much of my remaining non-index money is there to entertain myself, to indulge my market prognostication propensities while keeping my acting on those propensities away from amounts of money that would really matter.   So, while I don’t have ALL my money in index funds, I eat my own cooking; just about all of it is in index funds.  Of course, lately, all my money doesn’t amount to very much, but that is another issue.)

Many years ago, when I was managing portfolios at a big Chicago bank, I appeared at a forum sponsored by a major mutual fund company with whom we did business.  This particular family of funds, which will remain nameless, was and is primarily an active manager and an advocate for active management.  At this forum, I was there to represent the passive investing argument and the deck was stacked against me, but the sponsoring fund family was, and is, good people and I was confident enough in my argument that the set-up didn’t bother me.

After I made my pitch for index funds, the firm’s representative said something like (paraphrasing, not quoting; it was a long time ago):

What Mark is advocating is putting your money with a manager who has no brain.   Does that make any sense?

It looked as though he had me, until I retorted

Yes, I agree that an index fund has no brain.  But it also has no heart; it invests without emotions.  In your life, when you’ve made mistakes, was it because you weren’t smart enough to avoid those mistakes or because you let your emotions get the better of you?  

The answer, to most people was obvious.  I went on.

It’s the same with investing.   For the most part, money managers are very smart people.  (Perhaps I exaggerated a bit here, but I digress.)   It’s not a lack of intellect that gets them into trouble.  It’s their emotions.   They won’t sell a losing position that is getting worse.  They won’t add to a losing position that is only becoming an even more compelling value.  They continue to add to a winning position that has gotten way too rich.  It’s human nature that leads to investment mistakes.  Index funds eliminate the emotion from the process.  So, yes, I would rather invest with a manager with no brain…as long as it also lacked a heart.

I don’t know whether I won the day there, but I was quite happy with my defense of index funds and passive investing.  I have more or less stuck to that philosophy until this very day and probably will for the rest of my life, with at least one caveat:

Index investing does not entirely remove the emotion from investing.  Effective index investing (or even active investing) still requires nearly religious rebalancing (See, inter alia, Bill Gross Has A “Bad” Year:   Lessons For Your Portfolio, Rant Lifestyle, 1/4/14) and emotion can certainly get in the way of effective rebalancing; who wants to sell “winners” to buy “losers,” which is one of the things rebalancing forces us to do.  So to nearly eliminate all emotion from investing, even the dangerous emotions that come into play at rebalancing time, one would have to invest in a balanced index fund, or set up an arrangement in which your index funds are automatically rebalanced for you by the fund company.  Such arrangements are growing increasingly common.  Or you can do what my clients (at the time, mostly institutions) did:  hire a manager to do the emotionally wrenching things for you.


If you want to entertain yourself, do what I do:  watch “The Godfather” again, read a compendium of the musings of H.L. Mencken, watch “Shark Tank,” drive long distances in a car with a manual transmission and satellite radio, watch Big 10 football and basketball, read and write about politics…and maybe trade a few dollars like a scalded dog and hope to keep your underperformance, or outright losses, reasonable.  If you want to invest sensibly, buy index funds and religiously rebalance.

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