So we’ve identified the two basic ways you can invest. That’s great, but how do you know which one to choose? Let’s talk about the active option.
Active investing feels right. We’re active people after all. We shop around for deals, we love sales and Facebook Marketplace. We check weather forecasts on the regular, we set future plans on our calendars. We do research before we buy things (some of us perhaps to a fault), we read reviews, we ask our friends. All of these things are active. So then active investing just seems like the normal way to do things, look for underpriced companies, do some stock research, make a prediction about the future, nothing too out of the ordinary, right?
There’s just one small problem, investing isn’t like normal life. We’ve got really smart people positing that the stock market is efficient, which means there aren’t actually and sales or deals on underpriced companies. Sure, stock prices will generally move upwards, but not because a company is underpriced. New news and information comes into the market and affects stock prices, new things happen that we can’t know for sure beforehand are going to happen. Research into specific stocks is great, professionals are doing it all of the time, but no one person can possibly have a complete understanding of a company, let alone how unknown events in the future will affect the company. There’s just too much data to make picking stocks a long-term viable strategy. Predictions in the stock market are not like weather predictions, we don’t have a radar watching a storm-front move in. And if people believe there is a storm front coming, it’s already priced into the stock prices because again, the market is efficient.
It’s really tough to be a good active investor. Even professionals fail to outperform the market at an extraordinary rate (over the last 15 years, 92% of active funds trading in the S&P 500 have underperformed the S&P 500), and even those who seem to be good at it tend not to repeat their performance. So maybe you’ve guessed by now, I don’t advocate active investing. If you really believe that the market is not efficient and that you or someone you know has a special ability to buy and sell the right stocks at the right time then active investing is the way to test your belief. Unfortunately, the odds are not in your favor.
In part 3, we’ll talk about the alternative option.
If you’ve faced an investing decision at any point in your history you know it can be daunting. Maybe you’ve reviewed your 401k options within the plan at your work, how in the world should you decide which funds to use? Maybe you’re feeling the pressure to start saving for your future, how do you decide who would manage your hard-earned savings well? Conduct any amount of research and instead of settling anything you’ll find innumerable different philosophies and strategies and a lot of recommendations to ‘invest in what you believe in.’ Well, I’m going to try to help you understand the first decision you have to make.
The first decision is actually pretty simple, there are only two options because there are only two ways to invest. You can invest your money actively or passively.
- Active means that either you yourself or someone you delegate to selects stocks and investments they believe will do well. At work in active investing is a fundamental belief that the market is not all that efficient and smart people can achieve better returns by only investing in the ‘right’ things.
- Passive investing means that you don’t try to choose the ‘right’ companies or even market sectors. Instead, you own the whole market and hold it passively. At work in passive investing is a belief that the market is mostly efficient, and probably better at setting prices based on supply and demand than you are.
You certainly aren’t done making investment decisions when you’ve answered this question, but it’s the first thing you need to interact with. So when you start evaluating, start with this question, will you be an active or passive investor?
We’ll dig into these options in part 2.
This passive investing/index bubble idea from a Michael Burry interview continues to circulate. The idea has appeal, not the idea that another recession is imminent, but the idea that we could accurately predict one coming, and that the cause could actually make sense to us. The argument is fairly simple. A larger percentage of people are buying index funds, especially the S&P 500, than ever before. Index fund investors tend not to analyze each company in the S&P 500, they simply buy the index which owns all of them. So Burry worries that since fewer and fewer people are conducting analysis on company fundamentals, the prices of these companies are going to be inflated by virtue of the simple fact that they’re included in an index, not because they’re good companies that people believe in. That makes sense. The question then, is how much analysis and trading do we need in order to maintain a decent level of price discovery in the market? If index funds stifle price discovery, how do we avoid a bubble? Here are a few responses:
- Even a small amount of price discovery (studying fundamentals, making trades, supply and demand) makes a huge difference for prices to reflect value. We don’t need large swaths of the market conducting analysis.
- If 100% of invested assets were in index funds the price discovery argument might hold some weight. You would have to assume that there would be almost no company fundamental analysis happening, not an unreasonable jump but still an assumption. However, the truth is that only about 45% of invested assets are in index funds, and there’s still a host of investors and dollars outside of passive index funds working to set prices.
- Index investing actually adds data to the market, it contributes to price discovery. Instead of contributing data on specific stocks, it contributes to larger market sector data as people commit dollars to different indexes across the world, which is helpful market data.
- Despite the growth of index fund investing, global stock trading volume has actually remained about the same over the last ten years. People use passive vehicles to actively trade. Many index fund dollars are in ETFs among the most traded funds on the market. Just because money is in index funds does not mean that it’s passive. The activity all contributes to price discovery.
- Some passive investors (like us!) actually do use some fundamental analysis in constructing portfolios (structured funds). And even our passive investors occasionally make trades; in order to rebalance, when they make contributions or withdrawals, etc. Even the most passive investors contribute to price discovery.
- If the market was losing efficiency and price discovery as a result of growing index fund investors, we would expect to see an uptick in active money manager performance. Active managers would find the mispriced companies in the index and reap corresponding rewards. But the data shows no improvement, active managers have performed slightly worse over the last three years than before.
Despite the uptick in index and passive investing, price discovery is as strong as it ever has been in the stock market. Michael Burry’s comments on the index bubble are interesting and even sound plausible, but upon close inspection look misguided. Passive investing is still the way to go, though you do have permission to dump those index funds.
Alright, so we know passive investing trumps active investing, and we know that index investing, while passive, has some serious deficiencies. So what’s left?
We want to own the market passively, but that doesn’t mean we’re restricted to index funds. There is a much more responsible way to allocate money to different companies and sectors – structured funds. Structured funds deal with each of the index funds issues:
1. Instead of an arbitrary grouping of companies, a structured fund can make it’s own set of rules to decide which companies are in an asset class or fund and which are not. The S&P 500 is 500 of the largest companies in the U.S., but what if that’s not the best way to own the U.S. Large growth asset class? The same question can be asked of any index. Instead of abiding by the arbitrary index rules, a structured fund makes its own rules based on a century of market data. Just like the S&P 500 has rules to decide which companies are in and which are out (largely based on that 500 number), a structured fund has a set of rules that a company has to meet (size, profitability, book to value ratio, etc.) in order to be included in that fund. It’s still passive (in fact, often more passive than index funds), the rules are what determine which companies are in and out not an advisor’s gut feelings, but it’s a different type of investing. And it’s based on actual market research instead of arbitrary measurements.
2. We know that small companies outperform large companies over time, but indexes, by necessity (because of cap-weighting), own the least amount of the small companies. Even small company indexes like the Russell 2000 (which owns the smallest 2,000 companies in the U.S.) have much more money invested in the larger several companies than in the smaller hundreds of companies. If you’re in a target dated fund (the ones with a year at the end) in a 401k or a total U.S. market index fund, you’re missing out on the best returns the market has to offer because of cap-weighting.
3. Structured funds are not as cheap to own, and they’re much more scarce than index funds. You’ll probably have to work with an advisor to gain access to them. They rarely let investors put their finger on the trigger. Over time, these funds outperform traditional index funds because they’re designed to maximize return. An index fund would have to pay you to achieve similar returns, even after the additional costs of structured funds are considered. And because investors can only access them through an advisor, the likely-hood that investors consistently realize the returns (instead of hopping in or out or all around at the wrong time) increases significantly.
Often times index funds are the only decent option available (this is true in many 401k accounts), but when the options are open, a good advisor offering good structured funds is the best option.
Passive index investing has seen significant growth over the last 30 years as an alternative to active (stock picking) investing. Studies surrounding active investing have shown that on the whole, active investors underperform the market significantly, for two main reasons: high fees and poor stock selecting. As people come to grips with the problems inherent to active investing they naturally turn towards index funds, which seems to solve both of the problems listed above. Index funds are typically very cheap to own (solves the fee problem), and instead of actively picking stocks, they simply own sections of the market (solves the poor stock picking problem). Sounds pretty good, right?
Well, it’s definitely better than an active investment strategy but index funds are not without their problems, and they’re certainly not the best way to invest your money. Here are a few issues:
- An index is arbitrary. The S&P 500 Index (the most popular index out there) was created more as a measurement than an investment vehicle. It’s simply a list of 500 of the largest companies in the U.S., there’s no magic to the number 500. But that’s the thing, indexes were not created to maximize investor returns or diversify into asset classes in the most strategic way, they’re just arbitrary measurements.
- Index funds are almost all cap-weighted. This is an important thing to note. What this means is the larger the company, the larger percent of the index it takes up. In the S&P 500, the largest 10 companies take up 20% or more of the entire index while the bottom 10 companies take up less than 0.2%. In any index, most of your money is going into the most valuable several companies instead of being evenly diversified. A total U.S. market index fund, while seemingly offering lots of diversification, is almost entirely loaded up in the largest companies because of its cap weighting.
- Index fund investing often puts your finger on the trigger. Many index fund investors do their investing on their own since you can own an index fund yourself for a fraction of the cost you could pay an advisor to put you in the exact same fund. I’ve made this point in the past, but when it’s as easy as the click of a button to pull money out of an investment account, people tend to make mistakes. The S&P 500 for instance, has averaged about a 10% return per year for almost 100 years, which is fine, not great, but fine. However, from 2000 to 2009, it averaged a -1% return per year. It doesn’t matter how low the fees were or how well it compared to the stock-picking accounts, precious few of us would have stuck around for those returns over 10 years if we could move the money with the click of a button. Successful investing requires good coaching. Good coaching should include a better portfolio than a bunch of cheap mutual funds.
So what’s the alternative? Stay tuned for part 2.