Index Funds Aren’t Worth the Trouble

04/03/2012 12:26 pm EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

Sold as a cheap alternative to active management, they cap the upside without mitigating the inherent risk of stocks, writes senior editor Igor Greenwald.


Thirteen years ago this would have been a bulletin from a big wire service, sending premarket futures sharply higher and ultimately adding billions to valuations.

This morning, that was a tweet from the popular Zero Hedge blog, and no one took it as anything other than a punch line.

So yeah, Abby Joseph Cohen, the longtime Goldman Sachs (GS) markets guru, hasn't changed much over the years. But we have.

Back then, equity mutual funds regularly garnered monthly inflows of $25 billion or more, despite nosebleed prices at the tail end of an 18-year bull market. Now, three years into an upswing that has seen the market more than double off its March 2009 bottom, investors are continuing to pull cash out of such funds.

Some of that can be laid to the general disillusionment with stocks, which have provided plenty of chills and spills throughout this bull market. Even corporate pension plans have found the volatility of 2010 and 2011 too much to handle, and as a result continue to hide out in bonds, whose historically low yields are almost certain to disappoint in the long run.

But while stocks have bounced back each time they've taken it on the chin, our onetime faith that the financial arena rewards intelligence, experience, and skill has proven much more fragile. The prevailing wisdom is that these qualities may not be positively correlated with returns, and even if they are you'll have better luck playing the lottery than correctly identifying those who are about to capitalize on such advantages.

For example, The Wall Street Journal's Jason Zweig had a fascinating column this weekend on the investing record of the great economist John Maynard Keynes, in his capacity as manager of his Cambridge college's endowment.

After failing to anticipate the 1929 crash as a middling macro-driven manager, Keynes transformed himself into a fundamental value investor willing to take risks now associated with hedge funds. That strategy delivered nearly 20% annually over the last 14 years of his life.

It helped to have correctly picked miners rather than banks as the major beneficiaries of the post-Depression currency devaluations, and to have bet 66% of assets on that sector in 1936, the sort of concentration no modern college endowment could stomach. It also helped to be a risk-taker in an era that eschewed risk even more than we do now.

Keynes defined the long-term investor, and Zweig defines Keynes as "eccentric, unconventional, and rash in the eyes of average opinion." He was, in short, Jon Corzine-with more luck and without the killer leverage.

Zweig's takeaway from all this is to conclude that most of today's far more constrained fund managers aren't worth the fees, and that unless one can find a real free spirit (hey, Corzine is available), one might as well buy a low-cost index fund.

Which is exactly what mom and pop have been doing lately with money pulled out of actively managed vehicles. After all, there are all sorts of studies about showing that it's almost impossible to identify an outperforming manager ahead of time, or to ascribe his outperformance to anything other than luck.

Last summer, David F. Swensen, chief investment officer at Yale, condemned the mutual-fund industry as essentially worthless in The New York Times. More recently, Henry Blodget of Business Insider and Yahoo's Daily Ticker has suggested that anyone who still believes in active management is by definition the "muppet" of alleged Goldman ridicule.

So there you have it: skills proving elusive, the obvious thing for everyone to do is to join the herd and seek to be perfectly average. Because at least if you lose, you won't lose more than the next schlub, and won't have overpaid for the privilege.

And after the last investor has availed himself of that advice, the closing S&P 500 value will be the only number anyone need follow. Once everyone's in index funds, subsequent changes in the relative merits of, say, Apple (AAPL) and Yahoo (YHOO) will only be acknowledged by the market when the Standard & Poor's index committee decides to kick the latter out. (Index funds are actively managed too, only they leave that bother to the custodians of the index they follow.)

This is a fantasy, of course. But it does highlight the fact that in an environment where everyone has opted for the presumed safety of the herd those willing to graze elsewhere are probably better protected and better placed to profit.

The more people buy index funds, the greater the rewards of independent research into investments that index funds underweight or ignore entirely.

Right now, the preference for index funds is being cast by some of the savviest market commentators as the antidote to celebrity investing and the chasing of returns. The paradox is that the more people follow that advice, the better things will look those willing to strike out on their own.

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