Carpe Diem

More evidence on the superiority of index investing — most active fund managers can’t even beat a blindfolded monkey

In two recent articles in the New York Times Your Money section, business editor Jeff Sommer wrote about the superiority of passively managed index funds over actively managed funds. Sommer cites a June 2014 study by S&P Dow Jones Indices titled “Does Past Performance Matter? The Persistence Scorecard,” which provides some new, recent evidence that bolsters the case for investing in passively managed index funds.

Here’s an excerpt from Sommer’s first article on July 19 “Who Routinely Trounces the Stock Market? Try 2 Out of 2,862 Funds” (emphasis added):

The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn’t guarantee future returns.

The S&P Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)

The team selected the 25% of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

The answer was a vanishingly small number: Just 0.07% of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.

The study sliced and diced the mutual fund universe in a number of other ways, too, each time finding the same core truth: Very few funds achieved consistent and persistent outperformance. Furthermore, sustained outperformance declined rapidly over time. And the report said, “The data shows a likelihood for the best-performing funds to become the worst-performing funds and vice versa.”

What should investors make of these findings? There is one clear implication, said Keith Loggie, senior director of global research and design at S&P Dow Jones Indices.

“It is very difficult for active fund managers to consistently outperform their peers and remain in the top quartile of performance over long periods of time,” he said. “There is no evidence that a fund that outperforms in one period, or even over several consecutive periods, has any greater likelihood than other funds of outperforming in the future.”

This seems to bolster the case for index-fund investing. After all, if a fund manager with a great year can’t be counted on to outperform other fund managers later, it’s reasonable to ask: Why bother trying to beat the market at all?

And here’s an excerpt from Sommer’s second article on July 26 “Heads or Tails? Either Way, You Might Beat a Stock Picker” (emphasis added):

Over the last five years, actively managed stock mutual funds have performed even worse than would have been predicted if the fund managers were flipping coins instead of picking stocks. The real-world statistics to which I’m referring were contained in a recent S&P Dow Jones Indices study that I summarized in last week’s column.

Briefly put, the results of the S&P study, “Does Past Performance Matter? The Persistence Scorecard,” were bleak enough on their own. They showed that very few mutual funds were able to consistently outperform their peers, and that those that did so in one given year were likely to be poor performers five years later.

In fact, only 2 out of 2,862 broad domestic stock funds were able to outperform their peers consistently over five years, according to one measure: performance in the top quartile of funds over five consecutive 12-month periods ended in March 2014. That’s an unimpressive performance, to be sure. And if you compare it with a series of coin flips — a series of random choices — it looks even worse.

The dismal results of the real-world fund managers were very close to what Burton G. Malkiel, the Princeton finance professor, once described as “a random walk.” “Taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the experts,” he wrote in his guide to investing, “A Random Walk Down Wall Street.”

As a group, managers who ran the 2,862 funds examined by S.&P. Dow Jones Indices didn’t do as well as a blindfolded monkey. The hypothetical monkey, or a serial coin flipper, beat them in several other tests, too.

These findings may suggest that rather than spending a lot of time and money picking stocks or stock fund managers based simply on past performance, you might be better off just flipping a coin. And that implies investing in low-cost, diversified index funds.

MP: As I’ve mentioned before, the fact that 70% of US investors don’t own a single passively-managed index fund (and many of the 30% of investors who do own at least one index fund may not be using them as the core of their investment portfolios), despite the proven superiority of index funds over actively-managed funds represents perhaps one of the greatest “market failures” and “market inefficiencies” of our time. The stock market might be highly efficient, but the investing habits of a significant majority of investors remains highly inefficient in my opinion. Thousands and thousands of investors spend millions of dollars on fees and expenses every year for actively managed funds to collectively lose them billions of dollars compared to having the core of their portfolios in passively managed mutual funds…..

HT: Warren Smith

45 thoughts on “More evidence on the superiority of index investing — most active fund managers can’t even beat a blindfolded monkey

  1. Question: What would the effects/outcomes be for investors at 100% indexing? Would active managers be able to add value as indexing approaches 100%? If so, at what percentage does the advantage tilt back to active management? Or how would one go about analyzing that?

    • it’s a good and interesting question.

      active/passive tend to go in waves.

      as more and more investors index, the price of equities in the indexes rises relative to those not in the index. over time, this means that you are getting more growth and earnings buying outside the indexes and that the return to doing so will rise until it exceeds being in the index.

      its like a pendulum.

      he difficult issue here is that indexes ARE driven by active management. the stock price moves are far from uniform in the S+P 500. so, separating the two is not easy or even necessarily possible.

      if we all indexed, that would be the same as basically not having capital markets at all.

      no one would even be trying to find good uses for capital or weighting relative risk and reward.

      clearly, such a thing could never happen.

      long before that, the advantages to stock picking would become so large as to attract capital away from indexes.

      just how does one even fund start ups if there is 100% indexing?

      how could there even be an IPO?

      how would we reward good companies with the strong currencies they need to cheaply buy bad companies and make them more efficient?

      the price of an index is already the result of a great deal of active investing.

      it is precisely active investing that creates a market for capital and allocates capital well.

      without this sort of efficiency, index investing would be FAR less profitable. if money were just allocated to the same 500 companies over and over in proportion to their existing market caps and regardless of their performance in terms of revenue and earnings growth, imagine what a stagnant and awful system we would have. it would make soviet communism look dynamic and efficient in comparison.

      in a certain sense, indexers are parasites riding on the host of active investors and benefiting therefrom. you can have active investors without indexes or indexers. but you cannot have indexers without active investors.

      this does not mean that one cannot make a nice or even superior return as such a parasite, but it does mean that if too many do so, it will greatly reduce the overall performance of the host.

      trying to figure out at what % of overall investment indexing would start to do real damage to the efficient allocation of capital and thus overall growth and returns would be a very interesting study, but i’m not really sure how one would go about it.

      • So sticking with US investments assume you go with a total stock market index, then what other equities are there to play with in the US. Or say you go with a fund that echos the FTSE Total world stock index (such as from Vanguard), what else is left for equities to work on. Now of course you will always have execs being paid in company shares and options.
        This of course does not affect the question of allocation between equities and fixed income.

        • lyle-

          if we all go with a “total stock market index” fund, how are new firms funded?

          and, of course, as everyhting is funded evenly or in proportion to existing market cap, how is capital allocation supposed to occur?

          how do we make sure it is efficient and that it goes where it will be put to the best use?

          if we all index, it would be like we had no capital markets at all.

          it would be like everyone in the us working, and then just splitting the money evenly.

          do you not see the bad incentives such a structure would provide?

          it would be a race to the bottom.

          the only think holding up the returns for the indexes is active investing. take out the discipline imposed thereby, and you get a soviet style non market.

          further, these indexes are not nearly as universal as you seem to think.

          the vanguard total world index has 6348 stocks.

          the US alone has over 5000 publicly traded companies.

          there are over 43,000 worldwide.

          that means it misses 86% of listed companies. seems like a lot left to work on to me.

          • Let all us little folk do the indexing. Then you have the VC folks who would fund the new stuff. If you have sufficient resources, one could invest in VC funds, but for most folks that would be a loosing game. Let the billionaries play the edges, since they can afford to take some baths in the process. The small investor is better off safe than sorry. Now if one wants to take 10% and gamble on the market that would be ok, but it would not be investments but speculation.

          • lyle-

            “Let all us little folk do the indexing. Then you have the VC folks who would fund the new stuff. If you have sufficient resources, one could invest in VC funds, but for most folks that would be a loosing game”

            i think you are still missing my point.

            if all the little folks switch to index investing, it would destroy the capital markets. your returns and the economy would be ruined by it because you would have destroyed the market mechanism for capital allocation, which is active. each additional investor who indexes, at the margin, reduces the overall return for the indexes and makes capital allocation less efficient.

            this may be a winning strategy for many individuals as individuals, but, if too many do so, you get a tragedy of the commons and the overall market is destroyed.

            equity markets are, first and foremost, an engine for allocating capital. indexing cannot serve that role.

            thus, it can never be the primary mode of individual investment without destroying itself.

            fortunately, the incentives for active investment cut in long before then.

            this is not to say it may not be the best plan for you. it might well.

            i am just pointing out that if everyone were to do it, we would all be ruined.

          • “equity markets are, first and foremost, an engine for allocating capital. indexing cannot serve that role.”

            You can’t actually buy an index. You can buy funds that somewhat attempt to approximate any of dozens or maybe hundreds of indexes, and people sell and buy those everyday for price movement of the underlying stocks. Even with indexes, unless the fund carries cash or they are a closed fund, which will not make it a true index, they have to buy and sell the stocks that make up the fund. I could see a problem with mutual funds if they made you sign a 20-year commitment to hold the funds and/or a lot more people pick that investment strategy, but otherwise index funds will have to adjust to market cap or equal weighting to keep the index tracking and buy-and-sell pressures from investors just as active funds must do.

            I don’t foresee any problems getting capital to those businesses who earn it by being profitable whether they are in one of the hundreds of indexes or not: Invest away in low cost index funds without fear :)

          • walt-

            the distinction you raise si so small as to be effectively meaningless.

            if you buy the SPY, your returns will mirror the S+P 500 so closely that any difference is negligible.

            of course, you can buy the index if you like.

            it would not be that hard to buy the 30 stocks in the dow.

            but, like lyle, i think you are still largely skirting my point here.

            indexing only works because it, as a strategy, is a small part of the market.

            the high returns on the indexes are driven by active investment.

            that is what leads to efficient capital allocation and corporate responsiveness to shareholders.

            if, say, 70% of funds were invested by indexing, then the returns on doing so would drop form say 7% to maybe 1% or even become negative.

            it would negate the notion of having capital markets at all.

            it creates an interesting combination of a prisoner’s dilemma and a tragedy of the commons.

            if everyone is an active investor, it creates the highest possible returns for the indexes.

            but such high returns incentivize people to become indexers and free ride. doing so reduces overall returns and efficiency, but, if the number who do it are small, not by much.

            but, if the number of people indexing becomes large, they all wind up worse off as overall returns plummet as the market becomes inefficient and stagnant and the economy slows because capital is being invested without regard to return.

            of course, such a system would then incent people to seek out active strategies outside the stagnant indexes, so, this tends to be self correcting.

          • I guess I am missing the point, morganovich. I don’t make my living at this like you do, so I assume you are seeing something I don’t in your analysis.

            Spy actively trades, so if more people sell SPY today than buy SPY, the fund either has to sell the underlying stocks that make up the index to cover that or have a cash position to cover it. If they have cash, they are not tracking the index unless the return on the cash matches SPY’s return.

            I don’t see a problem with index funds allocating capital because many people are going to go with their gut and emotionally and actively invest anyhow, and there is no realistic way to stop that. There are so many different indexes and ways to index that one or more is always going to have better performance than others and people will start actively trading indexes to chase past performance.

            There’s a lot of research on whether equal weight or market cap is the best choice of indexing among other alternatives, so I doubt there will ever be a consensus everyone flocks to and stays that could conceivably cause inefficient capital allocation of investment dollars.

          • “Spy actively trades, so if more people sell SPY today than buy SPY, the fund either has to sell the underlying stocks that make up the index to cover that or have a cash position to cover it. If they have cash, they are not tracking the index unless the return on the cash matches SPY’s return. ”

            the effects of buying and selling relative to the size of the SPY and the enormous liquidity provided by computer driven arbitrage makes this difference so small as to be effectively zero.

            the current difference between the SPY and the S+P 500 is 2 one hundredths of one percent.

            that is to say, that per $1,000, it’s off by 2 cents.

            if that is not accurate enough tracking for you, i’m not sure what to tell you.

            you’ll lose a lot more than that just buying ans selling anything due to the bid ask spread.

            all index investors reduce the overall return to the market. equal weight or market cap allocation is irrelevant from this standpoint. each does the same damage by allocating capital based on things other than the financial performance of the underlying companies.

            because they are capital allocated without regard to how it is used they create inefficiency and diminish economic growth and capital appreciation.

            they are, in effect, free riders.

            note that i am NOT arguing that this means they should be prevented from doing so.

            what i am saying is that if everyone did it, we would have no stock market.

            there is actually an interesting parallel here to forcing people to pay representation dues to unions, a topic you seem to have strong feelings about.

            in that case, you oppose the right of workers not to pay union rep fees because they derive benefit (itself debatable) from the union’s bargaining.

            you refer to them as free riders and say they should not be allowed to get away with it.

            to be consistent, wouldn’t you then have to oppose the free riding of index investors? they are taking advantage of those who keep market returns and economic performance high by actively allocating capital, but they do not pay into the system.

            so, your positions here seem inconsistent.

            you like to be a free rider but argue against allowing others to do so.

          • I don’t think I have ever thought of index investing as deeply as you have, morganovich. I don’t think it will ever be much more than a hypothetical discussion item anyway because people are not machines and they are emotionally driven–especially about money. I would suggest low-cost index funds to friends without fear unless I see something new and different to change my mind.

            I think index investors being free riders is a bit of a stretch, but I don’t know enough about the intricacies of stock market trading to argue the point.

            Personally, I don’t worry about being consistent because I look at and judge everyone and everything on their own particular merits.

          • Walt

            Personally, I don’t worry about being consistent because I look at and judge everyone and everything on their own particular merits.

            Yes, you have repeatedly made it very clear that you are amoral and have no principles.

            To be consistent in this case, you would have to dislike free riders – people who choose to benefit without cost to themselves from the efforts of others – in every circumstance, not just those that you believe cost YOU something.

          • Ron, I see no inconsistency even if I were worried about it, but I’m not. I don’t connect my union affiliation and thoughts with my investing strategies whatsoever. I think any linkage along those lines would be very strange and possibly stifling. I compartmentalize my objectives and goals for each unique situation from each other so that I don’t limit my options.

            Personally, I think any talk about everyone suddenly being index investors and upsetting the stock market’s purpose of asset allocation or current index investors being free riders is ridiculous. I realize other people have different opinions, and I accept but don’t agree with them.

            I don’t visit and comment on economics blogs to make psychological or moral judgements about anonymous people I don’t know. I’ll reserve that discussion for real people I meet and know.

          • Walt

            Ron, I see no inconsistency even if I were worried about it, but I’m not. I don’t connect my union affiliation and thoughts with my investing strategies whatsoever.

            And that was the point. If you believe someone who benefits from the efforts of others, for example a non-union member supposedly benefiting from union presence is a free rider, then a non-investor who relies on the work and expertise of active investors and benefits from saying “I’ll have what he’s having.” would be considered a free rider also, no?

            I compartmentalize my objectives and goals for each unique situation from each other so that I don’t limit my options.

            Yes, you have explained that. Anything goes.

            Personally, I think any talk about everyone suddenly being index investors and upsetting the stock market’s purpose of asset allocation or current index investors being free riders is ridiculous.

            You don’t appear to understand what morganovich is telling you about market basics, and the words “everyone’ and “suddenly” haven’t been used here, so you can put that straw away.

            I realize other people have different opinions, and I accept but don’t agree with them.

            Morganovich didn’t offer an opinion.

            I don’t visit and comment on economics blogs to make psychological or moral judgements about anonymous people I don’t know. I’ll reserve that discussion for real people I meet and know.

            And yet you seem concerned when someone uses an alias, even though their real name doesn’t help you know or understand them any better.

          • Ron, I don’t really care what anyone thinks about morals or ethics here: mine or theirs. I can separate economics from that discussion.

          • walt-

            1. it is not a stretch. it is an obvious and provable fact.

            2. “Personally, I don’t worry about being consistent because I look at and judge everyone and everything on their own particular merits.” then you posses no ethics or principles. what you have just said is effectively “i look at what’s in it for me, then invent my ethics and principles afterward to support my self interest.”

            while such a policy is socially acceptable when, for example, making a free choice to buy an investment that someone else will freely sell you, it is very different when wielding coercive force to, say, demand fees be paid to you.

            how can you possibly reconcile supporting forcing workers to pay fees for representation and services they did not ask for or want but then seek to index invest, in effect, getting the same thing from active investors, but not want to pay them for their services?

            when they come with a bill, will you pay?

            “I compartmentalize my objectives and goals for each unique situation from each other so that I don’t limit my options. ”

            i have never seen someone brag about being a hypocrite and a might makes right totalitarian before.

            it’s just pure “gimmie”. do you seriously not believe in basic ethics or notions of “do unto others as you would have them do unto you?”

            given your stated indifference to consistency, morality, or allowing others to have the rights you demand for yourself, why should anyone care what you want?

            you are basically declaring a war of all against all.

            i had thought the union folks were a bunch of thugs and freeloaders, but i had no idea it was this bad.

            truly, you have views that are totally inconsistent with even the rudiments of a just society or even being a decent human.

            no wonder libertarian ideas frighten you so much.

            you have the morals of a totalitarian thug.

          • morganovich, I don’t care to discuss either your or my idea of morals here. Why do you insist on making an economic discussion into something so abstract? Is libertarianism a religion you feel a need to preach?

          • also:

            “Personally, I don’t worry about being consistent because I look at and judge everyone and everything on their own particular merits.”

            this statement is inherently false and self contradictory.

            you have no consistency, yet you judge on merits.

            judge based on what? by what principles do you judge? how do you define merit?

            are even those principles and definitions inconsistent? then how do you decide to do anything and why do you not change your mind all the time?

            this state of affairs you describe is impossible. if you have no consistent standards at all by which to judge outcomes then, quite literally, you are a madman. that is DSM defined insanity.

            thus, you are either deluded or a liar.

          • morganovich, why do you have to take a discussion about the stock market and index funds over to a rant about something else?

          • “morganovich, I don’t care to discuss either your or my idea of morals here. Why do you insist on making an economic discussion into something so abstract? Is libertarianism a religion you feel a need to preach?”

            no walt, it’s that i find your particular brand of immorality and hypocrisy to be repugnant.

            you lie and dissemble to try and portray your might makes right, hypocritical, and often coercive ideology as being open minded.

            you hide behind absurd tactical lies like having no consistent principles.

            then, when you get called on it and cornered on it, you claim you don’t want to talk about it.

            i’m trying to get YOU to see that your purported ideology is bankrupt and provably inconsistent and false at any level beyond might makes right.

          • morganovich, I think you’ve went off the deep end here. I feel like I am having a discussion with a madman about my morals or lack of morals that I refuse to discuss. There’s been enough said for now. Have a good night.

          • “morganovich, why do you have to take a discussion about the stock market and index funds over to a rant about something else?”

            i merely began by pointing out the inconsistency in your views on free riders. (you like to be one, you seek to coercviely prevent other from doing so and feel entitled to charge them)

            you are the one who made it abstract by making the absurd claims about consistency and the reprehensible one about compartmentalization.

            you are being proud of being a coercive hypocrite.

            why would i not oppose such ideas?

            if i were to speak in support of pederasty, would you not be justified in expressing moral judgement and disgust?

            of course you would.

            this is just me, expressing my disgust for your ethics and views.

            if you do not want them judged, perhaps you should keep them to yourself.

            this is just more of your hypocrisy.

            you wish to express such views as an argument, but not field arguments against such views in return.

            you may compartmentalize all you like in your head, but out here, it’s not going to be respected.

          • morg, I agree with your point that investing 100% of funds in indices would never work, but you go a little too far here:

            “if, say, 70% of funds were invested by indexing, then the returns on doing so would drop form say 7% to maybe 1% or even become negative.

            it would negate the notion of having capital markets at all.

            it creates an interesting combination of a prisoner’s dilemma and a tragedy of the commons.

            if everyone is an active investor, it creates the highest possible returns for the indexes.”

            I disagree with your notion that more indexing would necessarily drop overall market returns, because less people are then actively investing. It all depends on which active investors drop out for passive strategies. If you can only take out all the active investors who generally get outperformed by the indices, like say most active mutual funds, ;) you’d actually raise the overall market return, as that’d be less dumb active investors putting money into money-losing ventures. If you only took out all those active investors who do well, obviously the overall market return drops. Since 100% indexing means taking out all active investors, obviously that’d never work, but that doesn’t mean having less active investors is a negative: it depends which ones you have less of, the good or the bad.

            But the key question is: what is the sweet spot where the combination of indexing and active investing can product the best overall market return? And given how many active mutual funds get beaten by the indices, that sweet spot is likely much higher than it is today, ie much more indexing. As you say, if we ever get too much indexing, the returns from active investing will rise and indexing will decrease, so we don’t really have to worry about the extreme 100% indexing case.

          • I can separate economics from that discussion.

            No, Walt, you can’t. The study of economics is the study of human actions. Without any value judgments from the point of view of those actors, the exercise is meaningless. It’s not just numbers.

          • Ron, I’ll leave judging people’s values to someone a bit higher up than here. The reason I don’t try to judge other people here is I don’t think I am qualified to do so.

          • walt-

            “The reason I don’t try to judge other people here is I don’t think I am qualified to do so”

            funny, you sure seem to do a lot of it around free riders on union deals, libertarians, and people who are “dogmatic” and “idealists” which, by your definitions, seems to be anyone who actually has consistent values that extend beyond “gimmie”.

            once more, you seem to be trying to claim for yourself a right you seek to deny to others.

            your hypocrisy is certainly consistent.

          • spre-

            “I disagree with your notion that more indexing would necessarily drop overall market returns, because less people are then actively investing. It all depends on which active investors drop out for passive strategies. If you can only take out all the active investors who generally get outperformed by the indices, like say most active mutual funds, ;) you’d actually raise the overall market return, as that’d be less dumb active investors putting money into money-losing ventures.”

            i think you are missing the key aspect of this situation:

            the performance of the index is driven by active investing. it is not an independent variable, as you are assuming in your analysis.

            if it were independent, sure, if those who lose to it index and those who beat it are active, then you get higher overall returns.

            but it is not.

            it is a function of the active investment strategies that often lose to it.

            the more you take them out, even if they are under performing, the less well the index and the economy perform. it is then subject to less selective pressure.

            allocating capital without regard to return breaks the market signal. funding flows to the biggest instead of the best and the incentive for such forms to even try to serve investors drops as indexing rises.

            it’s basically communism.

            so, you get inefficient capital allocation, which leads to less growth, which leads to lower returns.

            you also get corporations that know they get money win lose or draw, so why try and why, for example, not pay the capital to management?

            why stay lean? why invest in new products when you get funded anyway?

            the “mix” you discuss doe not exist.

            even one index investor reduces the overall efficiency of capital markets, the economy, and the overall return to stock indexes. not by much, but it is a reduction.

            the optimal point for long term index performance and economic growth is 0% indexing.

            this is unlikely to happen, as the odd combo of a prisoners dilemma and tragedy of the commons here leads to high incentives for defection as individual maxima are not aligned with the collective maxima and the rights structure and profit stream is such as to preclude win/win coasian solutions to prevent defection.

          • morganovich, I voice my opinions expecting other people to do the same. I accept and can respect opposing viewpoints (or I would not be here :)

            I would never call someone who disagrees about anything with me immoral or unethical because that is not my place to judge another human being. A lot of people here seem to be unable to unwrap their economics, politics, ideology and/or religion from each other. I’m fine with that, but that’s not me.

          • walt-

            this is just more of your hypocritical double standards masquerading as open mindedness.

            when you, for example, support forcing people, against their will, to pay dues to a union for representation they did not ask for and may well not want, that MAKES it an ethics discussion.

            you are advocating the use of coercive force for what may well amount to extortion.

            that IS an ethical discussion. it’s no longer just economics.

            then, when you wish to free ride on others, you demand the right to do so.

            the combination of such things is not ethical and when you demand rights you refuse to allow to others, again, you have MADE it an ethical discussion.

            it’s just thuggery for self interest.

            hell, you brag about being amoral.

            then, you make inherently contradictory and impossible statement like this:

            “Personally, I don’t worry about being consistent because I look at and judge everyone and everything on their own particular merits.”

            and claim to compartmentalize your ethics so you have no problem being for free riders when you are one and against them when they ride on you.

            if you cannot see that such a thing is the very definition of a lack of ethics, principles, and integrity, then i really do not know what to tell you.

            i sure would not do business with you.

            what you are proposing IS in fact a particularly nasty for of ideology, you are just in denial that it is impartial.

            it’s like somewhere you read a book on unprincipled position bargaining and mistook it for ethics, and then somehow view that as impartial.

            you are, in effect, declaring the war of all against all.

            thus, you certainly have no right to complain when others war on you back. and yet you do.

            you speak to your own politics and ideology, then demand that others do not and try to hide behind that once you get cornered.

            truly, your hypocrisy knows no bounds.

          • “if you cannot see that such a thing is the very definition of a lack of ethics, principles, and integrity, then i really do not know what to tell you.”

            If you can’t see that I don’t mix economics, politics, and ideology/religion, I don’t know what to tell you. Again, I support your right to your opinions, morganovich. You sure seem to have what I consider some extremist viewpoints though, and you are very quick to start calling other people names who do not completely agree with you.

          • “If you can’t see that I don’t mix economics, politics, and ideology/religion, I don’t know what to tell you.”

            lol.

            more hiding behind trying to flip the debate.

            that is EXACTLY what you do.

            when you speak of coercing people into paying representation fees to unions they do not wish to belong to or be represented by, can you seriously claim that has no ethical component?

            forcing others to pay you is ethically neutral?

            seriously, what color is the sky on your world.

            this is like trying to discuss geometry with someone who claims that triangles sometimes have 3 sides and sometimes have 5 depending on whether it is your triangle or my triangle.

            you are deeply deluded walt.

          • “forcing others to pay you is ethically neutral?”

            There are costs to belong to any group whether it is smelling cow shit because you live next to a farm, noise because you live next to an airport, or taxes and dues because you belong to a group that imposes those fees. Wishing you are not part of a group does not make it so even if you don’t like it. You have three rational choices: pay, leave, or try to change the situation. I don’t see where ethics come into play in these case unless you are getting into extremist ideology.

            I would not call someone unethical or immoral because they did not like airport noise, flew airplanes over a house, or charged dues or fees to belong to a group. Where do you get the right to judge someone else’s ethics or morality?

          • I don’t see where ethics come into play in these case unless you are getting into extremist ideology.

            I would not call someone unethical or immoral because they did not like airport noise, flew airplanes over a house, or charged dues or fees to belong to a group. Where do you get the right to judge someone else’s ethics or morality?

            wow! Just wow. you really don’t get this, do you Walt?

            You completely deny the existence of choice. If I JOIN a group, I expect to pay the costs of membership. If I DO NOT join a group I shouldn’t be expected to pay, and shouldn’t get any of the benefits of membership.

            If you think hard about it, that applies to every one of your examples.

            Let me get you started on that exercise: If I move next to a farm, or a property that COULD be a farm, I may expect to smell cow shit. If a farm moves next to me, I may or may not expect to smell cow shit, depending on prior restrictions on the property rights associated with the property in question.

            Charging dues and fees as a condition of membership in a group is perfectly fine, and is ethical, if a person can CHOOSE to join and pay, or CHOOSE to not join and NOT pay. Someone might join a bowling league, and pay the dues and fees in order to enjoy the benefits of membership. They would NOT expect the league to force them to join and pay just because they bowl at the same bowling alley. This is EXACTLY what you are advocating with forced union membership, and it is UNETHICAL.

            You can work through the rest of your examples yourself. Hope this helped.

          • “Charging dues and fees as a condition of membership in a group is perfectly fine, and is ethical, if a person can CHOOSE to join and pay, or CHOOSE to not join and NOT pay. ”

            People who believe abortion is OK are thought to be unethical by some people. I’m not even going there or anywhere else you guys want to go on ethics. Everyone thinks their own ethics are the only ethics out there to the point of being fanatical about it.

            On the other point you made, Ron, you do choose either by joining in the first place or alternatively staying after the group has formed. There’s no doubt individuals can lose some things in a group, so either the gain overall is worth it, you take your marbles and go home by yourself, or you stay and try to make the group better realizing you aren’t going to win them all and that compromise is inevitable. Yeah, it can be messy at times, but it’s nice knowing someone has your back, too.

          • “They would NOT expect the league to force them to join and pay just because they bowl at the same bowling alley.”

            In this town, if you want to bowl in the winter, you will usually have to join a league (same for golf in the summer). That’s the bowling alley’s policy. There are very few open bowl slots available.

          • Walt

            In this town, if you want to bowl in the winter, you will usually have to join a league (same for golf in the summer). That’s the bowling alley’s policy. There are very few open bowl slots available.

            You can’t really be this dense, can you? Please tell me you are just refusing to concede my point.

            What you describe is the equivalent of an employer requiring anyone they hire to join a union. Not the same as a union requiring newhires to join.

            A bowling league couldn’t legitimately require everyone who comes into a private business, hoping to open bowl, to join the league.

            People who believe abortion is OK are thought to be unethical by some people. I’m not even going there or anywhere else you guys want to go on ethics. Everyone thinks their own ethics are the only ethics out there to the point of being fanatical about it.

            Irrelevant and meaningless nonsense.

            On the other point you made, Ron, you do choose either by joining in the first place or alternatively staying after the group has formed.

            No, Walt it just doesn’t work that way. I don’t need to join a group that forms around me. If I’m that farmer, people can’t move to adjacent properties and demand that I stop creating odors. If people build housing near an existing airport, they can’t legitimately complain about the pre-existing noise. If a bowling league forms at the bowling alley where I regularly bowl, I can’t legitimately be forced to join that league.

            Surely you understand the concept… don’t you?

            There’s no doubt individuals can lose some things in a group, so either the gain overall is worth it, you take your marbles and go home by yourself, or you stay and try to make the group better realizing you aren’t going to win them all and that compromise is inevitable. Yeah, it can be messy at times, but it’s nice knowing someone has your back, too.

            More irrelevant drivel.

      • morg,

        i think you are missing the key aspect of this situation:

        the performance of the index is driven by active investing. it is not an independent variable, as you are assuming in your analysis.

        if it were independent, sure, if those who lose to it index and those who beat it are active, then you get higher overall returns.

        but it is not.

        I don’t assume it’s an independent variable: the whole reason index returns would go up if subpar active investors got out is because index returns are not an independent variable.

        it is a function of the active investment strategies that often lose to it.

        the more you take them out, even if they are under performing, the less well the index and the economy perform. it is then subject to less selective pressure.

        There are different types of selective pressure, those that add information to the market and those that add noise or actively select money-losing investments. Taking out some of those noise/unprofitable active investors by putting less money in their hands and more with the passive indices leaves the performant active investors making more of the pricing decisions that set prices for the indices. That means more market return by taking out the wrong kind of “selective pressure” from bad active investors.

        allocating capital without regard to return breaks the market signal. funding flows to the biggest instead of the best and the incentive for such forms to even try to serve investors drops as indexing rises.

        it’s basically communism.

        so, you get inefficient capital allocation, which leads to less growth, which leads to lower returns.

        you also get corporations that know they get money win lose or draw, so why try and why, for example, not pay the capital to management?

        why stay lean? why invest in new products when you get funded anyway?

        the “mix” you discuss doe not exist.

        You are jumping to extremes here. Simply taking some money-losing active investors out of the market and passively investing that money instead will not lead to the “communist” extreme you lay out. Instead, it would be a more efficient market, that has investors who don’t know what they’re doing get out.

        even one index investor reduces the overall efficiency of capital markets, the economy, and the overall return to stock indexes. not by much, but it is a reduction.

        the optimal point for long term index performance and economic growth is 0% indexing.

        Don’t be ridiculous. There are plenty of people who want to invest their money but don’t know where to put it. They can either try to chase after the few good investors, invest in a bunch of dummy investors who don’t do that great, or passively invest in an index and just take what the overall market gives them. There is a balance, where you only have mostly good investors actively investing and the rest passively indexing, which is the optimum. To suggest instead that everyone should be actively investing to drive maximum market return is just silly. It assumes that all active investing adds value, which is contradicted by the data.

        this is unlikely to happen, as the odd combo of a prisoners dilemma and tragedy of the commons here leads to high incentives for defection as individual maxima are not aligned with the collective maxima and the rights structure and profit stream is such as to preclude win/win coasian solutions to prevent defection.

        I’d argue instead that the progressive drive towards more indexing over the decades is leading to a better collective maximum, as it’s driving the worse-performing active investors out of the market and making it more efficient.

        • “I don’t assume it’s an independent variable: the whole reason index returns would go up if subpar active investors got out is because index returns are not an independent variable. ”

          this is not the case. if the pool of capital stayed the same and only the best investors all got more to allocate, yes, but that is not how it works in the case of indexing. it takes money out of the pool and invests it without regard to the underlying companies. this attenuates the price signal. it will still have an active component, but it will be lessened and get worse over time as more and more assets are allocated based on an index rooted in the past.

          the better investors were already in the price signal.

          they do not become a greater part of it because others move to indexing. the nature of the noise just changes and the overall efficiency drops as capital is not being invested without even trying to be a signal, which, in and of itself, creates a signal and promotes further chasing of inefficient behavior.

          you also presume that all the worst investors will go to index funds. this is highly doubtful. many of the worst investors think they are good investors just as 90% of people think they are above average.

          my point on communism was describing the extreme, which is to say, what if we all indexed? if everyone was an indexer, we would have no capital markets.

          if everyone is active, we get the most efficient possible markets.

          in the middle, it slides on a spectrum.

          ” It assumes that all active investing adds value, which is contradicted by the data.”

          you have completely missed the point here and are, again, assuming that index performance is an independent value. i know you say you are not, but you are.

          the fact that the index outperforms many active strategies is NOT proof they are not adding value.

          they are what drives the index performance. the fact that the sum of the effect exceeds most of the parts does not mean that they are not adding to the total.

          even one index investor at the margin pulls us away from the maximum efficiency frontier.

          it’s like we are a mass of people tied together and swimming.

          some are fast, some are slow. if we all swim actively, that is maximum speed. if one guy decides to be passive and just go along, even if he is the slowest guy, we are now going slower. if everyone copies him, we stop moving entirely.

          you are not thinking about this correctly.

          you are assuming that the slow guy drops off, leaving just the best active swimmers, but that is NOT what happens.

          driving out the worse performing active investors (presuming that happens which is, itself highly questionable) and replacing them with a strategy that does not care at all is a decline in efficiency, especially compared to giving that money to the best active investors instead of indexing.

          the notion that markets are made more efficient by people going passive is simply baseless. it subtracts information and efficiency fro the system. it’s like claiming our group of swimmers will be more efficient if the slow guys just float and let the fast ones pull them.

          • It seems like we’re going in circles here, so I’ll be brief. My point is that the price signal does get better if we replace bad active investors with more indexing, as that leaves only better active investors making pricing decisions. I don’t “presume” that worse investors will be replaced by indexing, that is in fact the most likely outcome. Who’s going to switch over to indexing, those who were already beating the index? Come on. The fact that everyone indexing would never work doesn’t imply that nobody indexing is the best outcome.

            I will agree with you that just because some active investors get beat by the index doesn’t mean they aren’t adding value. They may be focused on certain markets that are inherently low-return and cannot be compared to high-return markets that lift the total market return up. Somebody needs to invest in those low-return markets because they produce valuable goods, whether food or raw materials, that happen to be commoditized.

            But you keep ignoring the fact that there also exist active investors that don’t produce value and we’d all be better off if that money were invested in passive indices instead, where that money would at least passively mimic the best investors rather than actively destroying value. In your swimming analogy, these aren’t merely the slow swimmers, these are guys who are actively swimming in the opposite direction. If we can at least get them to do nothing, ie passive investing, we swim faster.

            I’ll note that I’d call someone a bad investor from long-term returns, not from getting beat by the index or benchmark by a quarter or a year. And as long as people are choosing where there money goes, the current market is already optimal from one perspective: it’s their choice who to put their money with, whether active or passive, as opposed to it being forced on them. But the fact remains that many are making bad choices and would be better off indexing rather than putting their money with provably clueless active investors, based on their long-term track record.

  2. while i certainly have little faith in active mutual fund management as the system is rigged against them (those who can outperform keep getting given more assets until they can’t), this methodology is not really meaningful.

    “The team selected the 25% of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

    The answer was a vanishingly small number: Just 0.07% of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.”

    why would that matter?

    you do not have to beat the market every time, just over time.

    eg.

    imagine the S+P returned +5%, +16%, +5%, -37% (those are real numbers)

    now imagine a fund that returned 4%, 15%, 4%, and 4%.

    the S+P beat them in 3 of 4 years.

    but the fund crushed the S+P over those 4 years.

    which one seems like a better savings vehicle?

    the conclusions he cites cannot be supported by the methodology he uses.

    they may even be true, but sommers has certainly not shown that to be the case and i would tend to discount the thinking of someone whose methodology is so poor.

    anyone trying to use such data as evidence simply does not understand what he is trying to measure.

    the long term case against open ended active mutual funds is strong, but his argument does not bolster it.

    it just embarrasses sommer (assuming such a thing is possible for an NYT writer)

  3. I’ve been mostly invested in index funds since I got my MBA, but after this last series of posts, I’m now 95%+ into index funds. The rest is “gambling” for entertainment.

  4. What is sad is that many state and local pension funds hire expensive money managers….they even hire consultants to rate the money managers…

    • Most pension funds (and endowment funds) do not have an objective of maximum return. The amount of risk needed depends on how healthy the fund is, the amount of funds available for new investment, and what return is needed to meet current and near current liabilities. You don’t need to assume risk associated with 18% returns if 5% returns from a fully funded plan will do the job you need to do. Many pension funds have dialed back their current equity exposure to 20-40%, so you can’t use the SP 500 as a benchmark.

  5. Note that according to this wikipedia article only about 11.5% of us equity mutual funds are index funds, and add to that the number of individual stocks held, and you have a lesser percentage. http://en.wikipedia.org/wiki/Index_fund

    Of course if you decide to manage your own funds the cost is just your time and possible periodicals. No mutual fund fees if you buy the stocks directly. (in particular with the low to zero commissions charged by discount brokers plus you avoid the useless advice of the broker peddling his firms trash products.

  6. Love your blog and I agree with you with almost everything you write including that many investors would be better off in index funds because very few money managers can beat the indexes after expenses. That said this article implies that an adviser has to be in the top quartile each time five years in a row in order to provide exceptional results.

    Point 1. No strategy works 100% of the time but one that works most of the time could supply superior results without always being in the top quartile.

    Point 2. Taken over a five year period, compared to their peers, half of the advisers provide above average results. So what? Which brings me to

    Point 3. The real comparison should have been against an index not against their peers. We don’t know from this study if 1% or 100% of the advisers could beat a passive index fund strategy.

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