We write about many topics on this blog. One consistently popular topic is investing.
It’s honestly hard for me to wrap my head around why our investing posts are so popular. Darrow annually publishes a post sharing his investment portfolio. Last summer I shared my portfolio and investment policy statement.
Our philosophies are similar. I could describe those philosophies in two words. . . simple and boring.
So I struggle to balance reader demand for content on index fund investing with my view that there’s not much new to write about.
I recently listened to Scott Riecken’s new book “Playing with FIRE.” In the book, Scott describes the challenges he and his wife Taylor encountered on their journey from living paycheck to paycheck to a lifestyle devoted to the pursuit of FIRE, financial independence and retiring early.
One challenge they faced was conquering the feeling of being overwhelmed when deciding to take control of their investments. It resonated deeply with me, bringing back challenges my wife and I faced several years ago when we decided to take control of our finances.
It is a challenge many of us face, and some never overcome. The problem is not a lack of information on investing.
The problem is that there is so much information. It’s challenging to sort through it all to determine what actually matters and what is just noise.
I got a stark reminder of this when I recently saw an article titled “Investors’ widely held beliefs about ETFs and index funds may be wrong” trending for several days on the internet. It was written by Brett Arends, an “award-winning financial columnist with many years experience writing about markets, economics and personal finance.”
The article reminded me why investing is so overwhelming to so many, and why it’s so important to continue to emphasize things that are important to become a successful investor.
What Beliefs Are Wrong?
The provocative headline of the article was followed by a picture of a woman staring at a computer screen with a shocked look. The article then starts:
“A new study has just shaken one of the biggest investment myths on Main Street.
An analysis of mutual-fund stock trades over the past two decades has thrown into question the rationale that has sent everybody and her grandmother stampeding into low-cost index funds and exchange traded funds.
That rationale: that even skilled fund managers can’t beat the stock-market indices, so there’s no reason to pay someone to try.”
A few paragraphs later the author continued:
“Instead, their research found substantial evidence that many skilled money managers are adept at picking stocks. ‘Mutual fund trades outperform their benchmarks,’ they wrote.”
All of this seemed like news to me. It goes against everything I’ve read about index investing, including annual SPIVA reports that seem to show overwhelming evidence that most actively managed mutual funds underperform the indexes they’re benchmarked against.
If the findings of this study revealed something different, I would indeed be shocked. And I would want to understand this new information. What is this new study and what exactly did it show?
The Value of “Average Returns”
Arends points out that the study “found the top 20% of funds beat the bottom 20% by a remarkable 1.27 percentage points a year. And the outperformance is even true when fund managers’ fees were taken into account.”
This is interesting, but should it shock anyone who invests in index funds? The entire premise of investing in index funds with a buy and hold strategy is that you are getting the average return of the index you are investing in.
Merriam-Webster defines average as “a single value that summarizes or represents the general significance of a set of unequal values.” Unless every value is identical, average results are the result of some results being above the average while some are below it.
If anyone is shocked that some funds in an index outperform the index average, then you don’t understand this basic premise of index investing or the mathematical concept of average. If the top 20% of funds beat the bottom 20% of funds by 1.27%, that means the other 60% of funds are somewhere in between.
The Impact of Investment Fees and Taxes
According to the website The Balance, the average mutual fund expense ratio ranges from 1.0% for large cap stocks to 1.2% for small cap stocks. The average expense ratio for S&P 500 index funds is .15%.
The value of investing in index funds means you get average returns without paying the high expense ratios associated with actively managed funds. Considering only the expense ratio of mutual funds, most funds will underperform the index.
But expense ratios are not the only fees incurred with a stock picking approach. Index fund investing also allows you to avoid paying trading costs and capital gains taxes that actively managed funds incur when trading securities in an effort to beat the index.
The ability to avoid this combination of high management fees, trading costs, and taxes is why achieving the average return of the index is so powerful.
Achieving the average return of the index means you will outperform the vast majority of, but not all, individual investors, mutual funds, and ETFs which in sum are the market. The fact that the margin between the top and bottom quintiles is only 1.27% only reinforces that point.
The Reality of Mean Reversion
The next point of the article is that active managers demonstrate skill when making “active trades” based on their analysis of a stock. In contrast, they are forced to make other trades because new money flows into and out of funds based on past performance which hurts subsequent performance.
It concludes that “mutual fund managers would do a better job if investors would just leave them alone.” This assumption may be correct, but it is irrelevant.
The reality is that investors always have, and likely always will, chase past performance. This is another pillar upon which the philosophy of being a buy and hold index fund investor is built.
Inflows into hot funds force some active managers to buy stocks even when they’d rather not. As funds underperform, investors tend to exit. This forces managers to sell when they may not want.
This is one factor leading to mean reversion, meaning funds that overperformed in the past tend to underperform going forward.
We all invest alongside others who tend to make irrational investing decisions based on fear and greed. It is wise to disregard hypothetical arguments and make investing decisions based on reality.
Most index funds beat actively managed mutual funds. That is reality. The longer you hold a fund, the more likely this becomes.
Misuse of Index Funds and ETFs
The final point the author makes is that most investors underperform the markets. He says we are our own worst enemies.
He writes: “Low-cost exchange traded funds and index funds are a response to the long term underperformance of “active,” stock-picking mutual funds. Ironically, though, they seem to address the wrong problem. They do nothing whatsoever to counterbalance the issue of mistiming. Quite the reverse: They’re so cheap and easy to buy and sell that they positively encourage Joe and Joanna Public to trade in and out.”
Again, there is nothing wrong or untrue with this statement. But it is nothing new and it shouldn’t be shocking to an index fund investor who has done his or her homework.
John Bogle wrote about using index ETFs to trade into and out of the market over a decade ago in his classic investing book “The Little Book of Common Sense Investing.” Bogle wrote:
“As to the quintessential aspect of the original paradigm–assuring, indeed guaranteeing, that investors will earn their fair share of the stock market’s return–the fact is that investors who trade ETFs have nothing even resembling such a guarantee. In fact, after all the selection challenges, the timing risks, the extra costs, and the added taxes–typical ETF investors have absolutely no idea what relationship their investment return will have to the return earned by the stock market.”
It is a fact that many investors don’t follow the buy and hold philosophy Mr. Bogle intended for index funds. This is a weakness of investors who do not follow Mr. Bogle’s philosophy.
It is not a weakness of the index funds themselves. This is not new and it should not be shocking.
In summary, this new study has not shaken my beliefs as an index fund investor. In fact, it provides more evidence that reinforces my beliefs.
The most important lessons about investing can be summed up in the first few lines of the serenity prayer:
God, grant me the serenity
to accept the things I cannot change,
the courage to change the things I can,
and the wisdom to know the difference.
You can change:
- Your savings rate
- Your investment expenses
- The amount of risk you take (asset allocation)
- Where you locate investments for optimal tax efficiency (asset location)
- Your behavior
You can not change:
- Future market returns
- Interest rates
- Other people’s behavior
I hope you found this article simple and boring. I hope nothing was shocking or new.
Simple and boring are exactly what you need to invest successfully. Once you understand that, investing is not that difficult.
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