Again Low Fee Index Funds Beat Active Managed

[Markola]

Arcyallen, I guess through experience and reading, my mind is made up regarding active vs. passively managed stock and bond funds. There is an Active Investing, Market Timing discussion on the Forum that you might enjoy more than I do. Good luck.

Beyond stocks and bonds, I readily agree that enough market inefficiencies remain to warrant paying an expert to guide an investor through the jungle. For example, if someone wants to invest in commodities or FOREX.

 

[ERD50]

In order to promote an actual discussion (which I didn't do in my first reply), what -possible- things would it take to "convince you" there's more out there than just indexes? If the answer is "nothing, my mind is made up" I'll accept that. But if you're open to new ideas/views, I'm happy to talk.

You present a false premise.

It isn't one or the other - my mind is "made up" based on what I know at this time. But I am open, and more than willing to be shown an alternative (who wouldn't want to consistently beat the market? I like money!)

But as just posted, and from other comments, "what it takes to convince me" is tricky. Not due to a closed mind (as some seem to infer), but because it is tricky!.

Five [-]Four, Three[/-] tough hurdles (probably all mentioned already, but I'll consolidate here):

1) If some fund manager has provided risk-adjusted market beating returns for some extended period, how can we know if that will continue? Even if it worked for a long time, markets change, will it work in the future?

2) That fund manager will retire or move on at some point - will the performance continue w/o him/her? Has a team been trained in the methodology to continue? Can they?

3) How do we know it wasn't also dependent on some luck? After all, the only way we can find the past winners is through a rear-view mirror, so we have applied "survivor-bias" to it. No way around that. Many, many, many funds just under-performed or dried up, or got absorbed.

4) If a team can be trained, that means there is a formulaic approach (which it really would need to be to be consistent/scientific, and not 'magic'). That means others can duplicate it. That will water down the approach if a significant amount of money is chasing the same investments. There's huge motivation to beat the market, it will be discovered.

5) And not only do they need to beat the market, they have to do it over and above their fees.

So even though there are never any guarantees, we are far from them with an active managed fund.


Counter that with the broad-based index fund:

1) We are practically guaranteed to stay extremely close to market performance, minus some small tracking error and minus some small fees.

2) It isn't dependent on a manager.

3) No one can "steal their secret" - it's public knowledge!

4) There is no question that there is no luck involved with an index, it just "is". History shows good tracking, and because there isn't judgement/decision involved, there is no reason to think that tracking won't continue.

So if you want to try to find the rare beast that out-performs, and risk that it continues, that's your choice and good luck. I prefer to take what I see as a reasoned, solid, long term approach.

-ERD50

 

[OldShooter]

I'll add a couple more hurdles:

6) There is almost 70 years of academic and industry research consistently showing that price behavior very closely matches a random walk. Consistent with trying to predict a random process, the research shows that the vast majority of stock pickers underperform their benchmarks over long periods of time. The randomness also guarantees that there will be occasional, but unpredictable, outperformance. This outperformance mirage has successfully fueled the stock pickers' marketing machines for decades.

7. If someone really is able to outperform, why would I expect to find him selling his expertise to me for a pittance? The mere fact that someone is employed as a stock picker strongly indicates that he has either (a) tested his skills and found that he cannot do well enough to make an independent living or (b) he is so sure of failure that he is afraid to try.

 

[Rianne]

In order to promote an actual discussion (which I didn't do in my first reply), what -possible- things would it take to "convince you" there's more out there than just indexes? If the answer is "nothing, my mind is made up" I'll accept that. But if you're open to new ideas/views, I'm happy to talk.

Pick your topic on this forum. Some are 45 pages long with lengthy, complicated discussions and disagreements/agreements. That's why this forum is so useful. We are monitored by moderators and they step in when things get too heated, off the subject, or political.

It's up to us to decide what is useful, truthful, researched, or opinion. Learn who's opinions you respect but may or may not agree with. Many here do extensive research on the subjects they comment on and often back up their opinion with links or quotes. I've learned not to be intimidated because I have learned so much more about finances and other things than when I first started on this forum.

There is goodwill, good recommendations, and good advice if you ask for it but you don't have to take it. It's a forum, after all. And one of the best on the internet, IMO.

 

[Montecfo]

It is interesting how "past performance is not indicative of future results" with mutual funds, but there is "no reason to believe indexes will not outperform active investing in the future".

Lack of an irony meter?

 

[Koolau]

You present a false premise.

It isn't one or the other - my mind is "made up" based on what I know at this time. But I am open, and more than willing to be shown an alternative (who wouldn't want to consistently beat the market? I like money!)

But as just posted, and from other comments, "what it takes to convince me" is tricky. Not due to a closed mind (as some seem to infer), but because it is tricky!.

Five [-]Four, Three[/-] tough hurdles (probably all mentioned already, but I'll consolidate here):

1) If some fund manager has provided risk-adjusted market beating returns for some extended period, how can we know if that will continue? Even if it worked for a long time, markets change, will it work in the future?

2) That fund manager will retire or move on at some point - will the performance continue w/o him/her? Has a team been trained in the methodology to continue? Can they?

3) How do we know it wasn't also dependent on some luck? After all, the only way we can find the past winners is through a rear-view mirror, so we have applied "survivor-bias" to it. No way around that. Many, many, many funds just under-performed or dried up, or got absorbed.

4) If a team can be trained, that means there is a formulaic approach (which it really would need to be to be consistent/scientific, and not 'magic'). That means others can duplicate it. That will water down the approach if a significant amount of money is chasing the same investments. There's huge motivation to beat the market, it will be discovered.

5) And not only do they need to beat the market, they have to do it over and above their fees.

So even though there are never any guarantees, we are far from them with an active managed fund.


Counter that with the broad-based index fund:

1) We are practically guaranteed to stay extremely close to market performance, minus some small tracking error and minus some small fees.

2) It isn't dependent on a manager.

3) No one can "steal their secret" - it's public knowledge!

4) There is no question that there is no luck involved with an index, it just "is". History shows good tracking, and because there isn't judgement/decision involved, there is no reason to think that tracking won't continue.

So if you want to try to find the rare beast that out-performs, and risk that it continues, that's your choice and good luck. I prefer to take what I see as a reasoned, solid, long term approach.

-ERD50

I'll add a couple more hurdles:

6) There is almost 70 years of academic and industry research consistently showing that price behavior very closely matches a random walk. Consistent with trying to predict a random process, the research shows that the vast majority of stock pickers underperform their benchmarks over long periods of time. The randomness also guarantees that there will be occasional, but unpredictable, outperformance. This outperformance mirage has successfully fueled the stock pickers' marketing machines for decades.

7. If someone really is able to outperform, why would I expect to find him selling his expertise to me for a pittance? The mere fact that someone is employed as a stock picker strongly indicates that he has either (a) tested his skills and found that he cannot do well enough to make an independent living or (b) he is so sure of failure that he is afraid to try.

Curious if anyone wants to argue against these posts. Back all those years ago, I thought there must surely be someone smart enough to beat the "system" but eventually, all the "high flyers" joined the also rans. Fees were always a drag. Yeah, I think my mind is made up until someone can show me something that disproves the idea that it's all more or less random, fees always hurt, none of us is smart as all of us, etc., etc. YMMV

 

[ncbill]

It is interesting how "past performance is not indicative of future results" with mutual funds, but there is "no reason to believe indexes will not outperform active investing in the future".

Lack of an irony meter?

The higher fees alone should mean actively managed funds underperform index funds even going forward.

IMHO the only way to make money consistently with actively managed investments is to own/manage such yourself.

 

[38Chevy454]

The higher fees alone should mean actively managed funds underperform index funds even going forward.

IMHO the only way to make money consistently with actively managed investments is to own/manage such yourself.

The bolded part is where the main argument that active managed funds have a hard time to beat the index over time. It is the drag of fees that must be overcome. To just break even requires beating the index by approx the fees of the active managed fund. That difficulty to consistently beat the index by at minimum the fee amount is proven by many of the previous replies.

I do hold FDGRX and have for a long time since long ago in my 401k. It has done great over the years. I believe it is an outlier vs the norm for active managed. I also think the success is also a function of the risk, as the FDGRX is by design a riskier growth type choice. For a long term buy and hold, plus continued investment such as in 401k contributions which are longer term, it is a good choice as part of a diversified allocation.

 

[ERD50]

It is interesting how "past performance is not indicative of future results" with mutual funds, but there is "no reason to believe indexes will not outperform active investing in the future".

Lack of an irony meter?

Couple questions:

1) You put that second part in quotes. Who are you quoting? Who said (or even inferred ) this? It would be helpful if you actually linked quoted statements that you are refuting, else they come across as a straw man you set up to knock down.

2) Were you referring to my post (#77)? But I said (bold added):

...

4) There is no question that there is no luck involved with an index, it just "is". History shows good tracking, and because there isn't judgement/decision involved, there is no reason to think that tracking won't continue. ...

I also don't think the two statements are necessarily at odds. OK, past performance, bla, bla... Now, can you provide a reason that in the future, a personal investor can identify the active funds that will outperform (in that future's future if you get my point)? I see no reason to think this is going to change. And I see no reason to think indexes won't track closely to the index.

Third question then: Where is the irony?

-ERD50

 

[Chuckanut]

It is interesting how "past performance is not indicative of future results" with mutual funds, but there is "no reason to believe indexes will not outperform active investing in the future".

Lack of an irony meter?

More likely it's fewer variables with the index fund. Especially in regards to management and how decisions are made. My 2¢

 

[ERD50]

To put another point on "past performance is not indicative of future results", that only refers to the performance in absolute terms. It says nothing about the performance relative to any alternative investment (which is also subject to that caveat).

I have no idea what the future performance of the index funds will be. So that statement about future performance holds. That has no bearing on whether they can be expected to outperform active funds in the future, but again, I see no reason for this to change.

-ERD50

 

[Koolau]

It is interesting how "past performance is not indicative of future results" with mutual funds, but there is "no reason to believe indexes will not outperform active investing in the future".

Lack of an irony meter?

Do you have any data that refutes the contention that index funds outperform active investing?

 

[Montecfo]

Couple questions:



1) You put that second part in quotes. Who are you quoting? Who said (or even inferred ) this? It would be helpful if you actually linked quoted statements that you are refuting, else they come across as a straw man you set up to knock down.



2) Were you referring to my post (#77)? But I said (bold added):







I also don't think the two statements are necessarily at odds. OK, past performance, bla, bla... Now, can you provide a reason that in the future, a personal investor can identify the active funds that will outperform (in that future's future if you get my point)? I see no reason to think this is going to change. And I see no reason to think indexes won't track closely to the index.



Third question then: Where is the irony?



-ERD50

ERD,

I enjoy your posts and hope this did not bother you. It was not aimed at you specifically, just at all the people who use the phrase I stated to talk down successful active management, but use same logic to talk up indexing. The quote was conceptual, but there are many examples here.

Do you still not see the irony?

 

[OldShooter]

... I have no idea what the future performance of the index funds will be. ...

No one can know, but there is a pretty strong inductive argument that the statistical aggregate of stocks will continue as it has for 100+ years, a random distribution with fat tails and a slight bias to the right (upward). That is why buy and hold works -- that slight bias.

Stock pickers can't take advantage of the behavior of the aggregate because they can only have a few stocks in their portfolio if their decisions are to have any impact. So they are at the mercy of the stocks they hold. Sometimes they are lucky, sometimes not, but their extra costs are always there. The biggest of these is the market impact of their trades, which is hard to estimate. I have read experts who think that it can be 1-2% or more, often exceeding the fund's published expense ratios.

 

[Montecfo]

Do you have any data that refutes the contention that index funds outperform active investing?

Do you mean that they will in the future? No one does.

But the statement "active investing outperforms indexing" is a nonsense statement.

So is "indexing outperforms active management".

 

[Exchme]

Do you mean that they will in the future? No one does.

But the statement "active investing outperforms indexing" is a nonsense statement.

So is "indexing outperforms active management".

I have accepted that not only are future macro trends subject to a lot of random chance (pandemic, war, legislation, etc.), but that investing is another step into the abyss of the unknowable in that the investor also has to guess how their own analysis and knowledge compares to all the other market players. So it seems unsurprising to me that study results show that you cannot know ahead of time which active strategy or manager will beat the market.

But as a passive investor, I am a free rider and the system cannot work if everyone thought that beating the "system" was pretty hopeless. Somebody has to believe they know enough more than everyone else in order to make the trades that create the price discovery process. So I thank you for your service, trading and incurring costs so I don't have to.

 

[ERD50]

ERD,

I enjoy your posts and hope this did not bother you. It was not aimed at you specifically, just at all the people who use the phrase I stated to talk down successful active management, but use same logic to talk up indexing. The quote was conceptual, but there are many examples here.

Do you still not see the irony?

OK, but no, I don't see the irony.

And I still don't know who "all these people" are. That's a common theme in some of the environmental/EV threads - "all these people do/say..." and it kinda bugs me, because how do we address this w/o an actual reference to the statement, so we can see if it was really said (or assumed or words put into mouths), and see the context.

My most recent post explains it (the difference between predicting future performance, vs some assumptions about relative performance), I don't think I can add anything to it.

Anything is possible, but many things are improbable. I think the ball is in your court on this (as Carl Sagan would say "extraordinary claims require extraordinary evidence"):

What assurance could your 'smarter than the average bear' personal investor have that their selection of an actively managed fund would have a reasonable expectation of outperforming a benchmark in the future? Past performance may or may not tell us much, Old Shooter has posted over and over the stats showing the 5 year winners don't have any persistence, they do no better the next 5 years than their peers. So what are the odds?

I have no problem with someone choosing an active fund with the hopes of getting a winner, their choice. I just don't see a compelling case for it for the average, or even the 'smarter than the average bear' personal investor.

I'd like to see you make the case, maybe I'm wrong.

-ERD50

 

[Koolau]

OK, but no, I don't see the irony.


I'd like to see you make the case, maybe I'm wrong.

-ERD50

Yes, I want to see the data. My mind can be changed.

 

[Montecfo]

OK, but no, I don't see the irony.

And I still don't know who "all these people" are. That's a common theme in some of the environmental/EV threads - "all these people do/say..." and it kinda bugs me, because how do we address this w/o an actual reference to the statement, so we can see if it was really said (or assumed or words put into mouths), and see the context.

My most recent post explains it (the difference between predicting future performance, vs some assumptions about relative performance), I don't think I can add anything to it.

Anything is possible, but many things are improbable. I think the ball is in your court on this (as Carl Sagan would say "extraordinary claims require extraordinary evidence"):

What assurance could your 'smarter than the average bear' personal investor have that their selection of an actively managed fund would have a reasonable expectation of outperforming a benchmark in the future? Past performance may or may not tell us much, Old Shooter has posted over and over the stats showing the 5 year winners don't have any persistence, they do no better the next 5 years than their peers. So what are the odds?

I have no problem with someone choosing an active fund with the hopes of getting a winner, their choice. I just don't see a compelling case for it for the average, or even the 'smarter than the average bear' personal investor.

I'd like to see you make the case, maybe I'm wrong.

-ERD50

There was nothing extraordinary about my statement which was not a "claim". I simply pointed out that index fans (and others) can often be heard to say "past performance is not indicative of future results" when running down actively managed funds. Yet those same people project past performance of indexing well into the future with little regard for the inherent contradiction.

I do not think most folks need links to "prove" this, but you said something similar yourself as have plenty of others including examples in this very thread!

 

[ERD50]

There was nothing extraordinary about my statement which was not a "claim". I simply pointed out that index fans (and others) can often be heard to say "past performance is not indicative of future results" when running down actively managed funds. Yet those same people project past performance of indexing well into the future with little regard for the inherent contradiction.

I do not think most folks need links to "prove" this, but you said something similar yourself as have plenty of others including examples in this very thread!

I really doubt that I said any such thing. Just doesn't sound like me.

When did I ever project the future performance of index funds? Where?

There's a few things that get my goat, and one is when someone says I said something that I didn't. If I did say it, show me. There must be an explanation.

Again, you must be confusing comparison of past/future performance with expectations of relative performance. And yes, based on sound reasoning, I would expect most active funds to under-perform a low-cost passive index. But that is not extrapolating future performance from past, relative performance is a whole different thing.

Say I have two thermometers outside. For the past 20 years, one always reads ~ 3 degrees below the other, because that's how they came from the factory. I can reasonably expect this to continue for the foreseeable future. Just like I can reasonably expect active to continue to under-perform passive.

That is entirely different from the use of "past performance is not indicative of future results" for investments. To apply that to my thermometers, I'd have to say that since it was X degrees average last August, I can expect X degrees average this August.

Two entirely different things.

-ERD50

 

[Montecfo]

I really doubt that I said any such thing. Just doesn't sound like me.

When did I ever project the future performance of index funds? Where?

There's a few things that get my goat, and one is when someone says I said something that I didn't. If I did say it, show me. There must be an explanation.

Again, you must be confusing comparison of past/future performance with expectations of relative performance. And yes, based on sound reasoning, I would expect most active funds to under-perform a low-cost passive index. But that is not extrapolating future performance from past, relative performance is a whole different thing.

Say I have two thermometers outside. For the past 20 years, one always reads ~ 3 degrees below the other, because that's how they came from the factory. I can reasonably expect this to continue for the foreseeable future. Just like I can reasonably expect active to continue to under-perform passive.

That is entirely different from the use of "past performance is not indicative of future results" for investments. To apply that to my thermometers, I'd have to say that since it was X degrees average last August, I can expect X degrees average this August.

Two entirely different things.

-ERD50

I am not confusing anything at all. Past performance cannot be both an argument AGAINST active investing and one FOR passive investing at the same time. Does not matter how you or I spin it or what the underlying reasoning is.

Now, other reasoning, guesses and conjecture are fine. But we should at least keep the arguments on point. And honestly, that is what makes the discussion rather unproductive: folks are so wedded to their views that are not willing to consider other views.

We have to admit that past performance does not predict future results for any style of investing. End of story.

Thanks for the discussion.

 

[ERD50]

I am not confusing anything at all. Past performance cannot be both an argument AGAINST active investing and one FOR passive investing at the same time. Does not matter how you or I spin it or what the underlying reasoning is.

Now, other reasoning, guesses and conjecture are fine. But we should at least keep the arguments on point. And honestly, that is what makes the discussion rather unproductive: folks are so wedded to their views that are not willing to consider other views.

We have to admit that past performance does not predict future results for any style of investing. End of story.

Thanks for the discussion.

The disconnect is you are taking two different kinds of "past performance" and comparing them. That's why I gave the thermometer analogy - the past performance of actual temperatures, and the past performance of relative temperatures. They are not the same. The passive fund and it's index are like the two thermometers. They track, regardless of past/future temperatures. Past 'performance' of temperatures doesn't come into it. If you can't get that, we are just talking past each other, so I'll stop on that point.

Regardless, I don't think you've ever answered the question: How does a personal investor pre-pick an active fund that has a reasonable chance to outperform in the future? Just on past performance? OK, but we gave a list of reasons why that may not persist, and the data shows it doesn't. Where does that leave the personal investor?

-ERD50

 

[all4j]

I'll readily admit to only reading a sampling of posts in the thread, but it is strikingly similar to many/most periodically that come up. Arguments devolve into rationalizing a point of view, logic & impartiality to the side...I've no desire to stoke that really.

But, I would be curious on an aspect that I generally don't see addressed. To me, a fundamental part of investing is taking risk...that is, you shouldn't expect a higher return if you don't take more risk. So these studies adjust for risk, volatility etc.....Hmmm. Have there been studies comparing CDs & corporate bonds -- adjusting for the things that make them different & then saying bonds don't provide higher return once we adjusted the data?

When I invest, I don't get adjusted returns. How is the study useful for anything other than generating clicks or feeding preconceived notions?

 

[ERD50]

I'll readily admit to only reading a sampling of posts in the thread, but it is strikingly similar to many/most periodically that come up. Arguments devolve into rationalizing a point of view, logic & impartiality to the side...I've no desire to stoke that really.

But, I would be curious on an aspect that I generally don't see addressed. To me, a fundamental part of investing is taking risk...that is, you shouldn't expect a higher return if you don't take more risk. So these studies adjust for risk, volatility etc.....Hmmm. Have there been studies comparing CDs & corporate bonds -- adjusting for the things that make them different & then saying bonds don't provide higher return once we adjusted the data?

When I invest, I don't get adjusted returns. How is the study useful for anything other than generating clicks or feeding preconceived notions?

Not sure if this answers your question, but to compare historical volatility/risk of an alternate investment, I use www.portfoliovisualizer.com and then adjust the bond portion until the standard deviation matches my target (maybe 70/30 VTI/BND or VFINX/VBMFX if you want to go back farther). Then I compare the final $$$ results.

If the alternative investment doesn't match the results of the benchmark after adjusting for standard dev, then I consider it to under-perform on a 'risk' (actually volatility) adjusted basis.

-ERD50

 

[all4j]

Not sure if this answers your question, but to compare historical volatility/risk of an alternate investment, I use www.portfoliovisualizer.com and then adjust the bond portion until the standard deviation matches my target (maybe 70/30 VTI/BND or VFINX/VBMFX if you want to go back farther). Then I compare the final $$$ results.

If the alternative investment doesn't match the results of the benchmark after adjusting for standard dev, then I consider it to under-perform on a 'risk' (actually volatility) adjusted basis.

-ERD50

Good explanation & I appreciate the time you took; unfortunately I don't think I communicated very well. In retrospect, not sure the point was worth making, but I'll try a bit different approach. I readily admit I may be assuming things about this specific study based on other studies I've seen in the past.

Assume a fund manager develops a better mouse trap -- claims to add 5% on top of what the market might give. For his/her expertise/trouble, he/she will charge me 1% more than the index fund going rate. He/she blatantly says they'll be taking on more risk (after all, shouldn't expect higher return without higher risk) than the market, but they have an approach to mitigate that risk.

I make the decision to buy in & lo/behold they deliver as hoped. I/we took on added risk & got higher returns, net 4% over the index fund.

I get a statement showing these results. It shows 4% more than the index fund -- it does not show adjusted returns stripping out risk from volatility. Now, I may make the decision to cash in my chips & walk away OR I may let it ride.

What I personally would do is say -- well if I strip out the non-market return but still apply the higher fee, how would i have done. No better than index? then why bother...all it did was leave with with more $s & higher taxes....

Hey, I'm not against index funds or active managed -- to me, both are tools in a tool box to be used as appropriate. But to strip out the pros & still apply the cons shouldn't take a study to guess the result....I saw something similar recently with another site where they stripped out inflation to review tips. Seriously.