I do not think it means what you think it means

By Slow Dad - June 17, 2017

Did you know most of the major stock market indices are actually actively managed? And you know what? The active managers do an amazing job.
That immortal line comes from one of my favourite movies, the Princess Bride. In this case I’m applying it to be concept of low cost index trackers being entirely free of judgement based decision making.

Warren Buffett says it: "...investors should stick with low-cost index funds."

Jack Bogle says it: "Index funds eliminate the risks of individual stocks, market sectors and manager selection, leaving only stock market risk"

What are they saying?

Low cost index funds will outperform active stock picking over the long term.

The logic here can be summarised by another Bogle quote: "Don't look for the needle in the haystack. Just buy the haystack."

Don't look for the needle in the haystack. Just buy the haystack.

So that is easy enough, go buy yourself a boatload of VFIAX and you’re done right?

Not so fast!

Did you know that the S&P 500 does not automatically contain the 500 largest US listed companies by market capitalisation?

In fact did you know that the S&P 500 composition is actually chosen by a committee of market professionals, known as the S&P Index Committee?

They meet regularly to review the current composition of the index, compare it to the actual top 500 market capitalisation stocks, and work out what (if any) changes should be made.

According to David Blitzer, the chairman of the index committee, “there are no rigid or absolute rules for the S&P 500”.

He cites the example of AIG nearly going bust during the Financial Crisis, and getting bailed out by effectively being temporarily nationalised by Federal Government. Normally that would have seen AIG removed from the index, however the committee realised that doing so would see index investors further dumping the stock which would only make matters worse.

there are no rigid or absolute rules

This point is worth considering

If the index was constructed the way many novice investors mistakenly believe, that is automatically composed of the current top 500 stocks weighted by market capitalisation, then the composition of the index would continuously be adjusting with the ebb and flow of the stock market.

Therefore index trackers would be required to continuously buy or sell their holdings in the underlying stocks contained within the index in order to try and match that index composition.

Sounds exhausting, right? And expensive.

But wait, doesn't that make the S&P500 index actively managed?

Larry Swedroe explored the argument that this meant the S&P 500 is actually akin to an actively managed portfolio, because the composition of the index is based upon the collective judgement and experience of a committee of investment professionals... just as an actively managed investment fund happens to be.

Ultimately Swedroe concluded that this was not the case, the index sought to broadly represent the overall state of the market, while active managers are deliberately trying to pick only the winners.

Ok, so the S&P 500 is weird, but the other indexes are all passive right?

If you think it is only the S&P500 index composition that gets determined in this way you would be wrong.

The FTSE100, the benchmark for the London Stock Exchange, is reviewed quarterly, with the 100 stocks drawn from a cohort containing the top 110 companies by market capitalisation.

The Nikkei 225, the benchmark for the Tokyo Stock Exchange, is reviewed even less frequently. The composition of the index changes only once annually, in October.

The Australian All Ordinaries Index is similarly rebalanced annually, in March each year.

Argh! Doesn't that mean everything I've been told about the superiority of passive investing is bullshit?

For what it is worth I think the committees behind these indexes do a great job. It is a rare thing to hear investors bloviating about a leading index not reflecting the actual state of a market it purports to represent. This means the committees themselves are largely invisible, as they should be.

The alternative would be something nobody would want to see, a repeat of the 1990s when idiotic analysts and gormless media pundits would attempt divine the content of Fed interest rate decisions based upon the colour of Alan Greenspan’s socks.

What does this mean?

Passive investing removes the need to worry about picking winners.

It lets investors (whether lazy/uneducated/disinterested or otherwise) piggyback on the combined efforts of every executive and employee who contributes to the profits of an index listed company. We may be parasites, but damn it we're profit sharing parasites!

What it does not mean is that the judicious application of professional knowledge and wisdom has no place in the investment world. After all the indexes are defined by such people!

 That isn’t a failing of the tools and techniques, it is a failure of the tradesperson wielding them.

So what?

The likes of Warren Buffett, Neil Woodford, Peter Lynch, and Benjamin Graham prove that there is a valid and valued place in the investing world for active investors. They are the master craftsmen of the investment world, the stock market equivalents of Frank Lloyd Wright, Hans Zimmer and Herman Miller.

It is just that the vast majority of us are not smart enough, lucky enough, experienced enough, patient enough or connected enough to be able to achieve the same sort of long term returns a passive index tracker will yield.

That isn’t a failing of the tools and techniques, it is a failure of the tradesperson wielding them.

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3 comments

  1. I'm guilty of this oversimplification myself, from time to time. Thanks for writing this, so I can parasitically reference it in my own blog! :)

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  2. I'm not sure I buy the logic that what Buffett and in particular Bogle says means that low cost index funds will outperform active stock picking over the long term.

    In particular what Bogle said is that the index investing approach eliminates much specific risk so that what remains is share market risk, which I presume to mean a broad (closely approximated) market cap weighted exposure to the asset class in your chosen region(s).

    What I'm at odds with is that risk is the potential of both *gaining* or *losing* something of value. We tend to only associate risk with the downside of that definition.

    I would agree that most of us aren't equipped to safely harness the upside potential so we should stick to a safety-in-numbers approach.

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  3. Thanks Cameron.

    What both Buffett and Bogle are saying is for stock picking investors to come out ahead they have to pick more winners than losers (or more accurately the performance of the winners they pick need to more than offset that of the losers). That is hard enough to do once, let alone being able to do it consistently year after year. It is certainly possible, but few manage to carry it off successfully.

    Your observation about risk is well made, there is certainly a risk of that you could have picked Apple, Amazon, Google and Facebook... then held on. The opportunity cost of choosing the soft (safe?) option and parking your money in an index tracker is certainly not benefitting as much from the very impressive performance of these stocks.

    If I had access to one of those Back to the Future style time traveling DeLoreans then I would certainly have done this.

    In the absence of access to a time machine I could have picked Enron, Worldcom, and ABC Childcare to invest in... oh wait, I did [sigh]. Which kind of sucked a little at the time (ok, a lot).

    Another way of looking at it is consider the Australian Poseidon nickel boom of 1969-70. A stock picker would have felt like a genius getting in September 1969 and selling in February 1970. However most people bought in once the media started talking about how spectacular the rise had already been, and then held on too long once the price started to collapse to avoid crystallising losses. The genius would argue stock picking was the best way to go, pretty much everyone else would concede index trackers would have worked out better for them.

    Woulda/coulda/shoulda aside, for most people most of the time it would be a safer bet to back the index and concentrate of beer and barbecues and whatever makes them happy rather than trying to pick not just the right stocks but the right timing.

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