Index Funds Are Nothing Special

I received some great feedback on my post from my post earlier this week on the challenges involved with beating the market (see: Something Most Investors Simply Cannot Accept).

But some people seemed to misinterpret my message. The point of showing the statistics on the underperformance of active management is not necessarily to convince someone that indexing is the only way to invest. It’s to show people that there are a few very important things you should pay attention to when choosing your investments. Index funds happen to provide a great example.

I’m on the record saying I think the index vs. active debate is the wrong question. Here’s what I said about this in my book:

An index fund is nothing special. It’s systematic, disciplined, rebalanced occasionally, transparent, low-turnover, low-cost, and low-maintenance. It’s one of the reasons they’re so hard to beat by even brilliant fund managers. You know exactly what you’re getting. Actively managed funds can do all of these things, even if they can’t exactly match the cost structure of an index fund. Instead of worrying about passive versus active, think in terms of disciplined strategies versus undisciplined strategies.

Also, there’s no such thing as passive investing anyways. Indexed investing doesn’t mean you can’t be active, just like investing in active funds doesn’t mean you can’t invest passively. Even those investors that rarely, if ever, make any changes and completely put their portfolio on autopilot have to make some decisions up front. There’s the target asset allocation, the fund types, asset location (tax sheltered or not), rebalancing intervals, and so on. Even the act of not making a decision counts as a decision.

In the future, simple portfolios will be extremely low cost while factor tilts will be cheaper than ever through a combination of competition and scale. Smart beta ETFs are already starting to turn a form of systematic active investing into this same type of process. But low cost and ease of access don’t stop investors from making mistakes. When the cost of a portfolio or a trade becomes a rounding error, it’s much easier to make changes. Emotions become the central component when costs are minimized. Behavior has always been more important than costs, but this will only be magnified as the cost structure falls. The biggest thing for investors is to understand what you own and why you own it.

I’m often asked which style of investing I practice or believe in, active or passive investment management. I don’t really look at portfolio management in this way. These things are never black and white. I believe in disciplined investment management. My goal has always been to gain exposure to certain asset classes and strategies in the most efficient way possible while considering the costs and risks invovled at all times.

So many people and organizations in the investment business would like financial consumers to believe that every move you make should be an all-or-nothing decision. This extreme approach is a great way to sell products, but it rarely helps people make better investment choices.

The definitions between passive and active don’t really matter as long as you have a well-thought out approach to portfolio construction and choosing each investment wisely. The biggest thing for most investors is to lay out some detailed guidelines about the products, fee structures or investment strategies that they won’t invest in. That reduces the number of decisions you have to make and decreases the odds that you run into paralysis by analysis and decision fatigue.

Index investing can work. Active investing can work. A combination of the two can work. But it all depends on how disciplined you are and how you choose to implement. None of the different investment styles matter if you’re not able to follow-through within the context of a broader investment plan.

Further Reading:
Portfolio Management & Decision Fatigue

Here’s what I’ve been reading this week:

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Discussions found on the web
  1. Matt Downing commented on Sep 18

    Thanks for writing this. I am a fan of index funds because they seem to be the most cost effective. But this article helped calm my fandom and forced me think in broader and better terms. I am always trying to get the cheapest deal. This is true with electronics, plane tickets, and also stocks. But as this points out, the cheapest is not always best if it doesn’t fit into a broad plan. http://www.13monthsecuador.blogspot.com

    • Ben commented on Sep 18

      It should always be a cost/benefit analysis and I do think you could always, always, always to way worse than an index fund. But there are times when an active approach can add value if/when used the right way.

  2. Grant commented on Sep 18

    I agreed that behavioural issues are the most important elements in a successful investing outcome. But with costs likely next on the list of importance, wouldn’t you agree that most of the time that will lead to index finds over actively managed funds?

    • Ben commented on Sep 18

      Agreed. Index funds make sense the majority of the time. But it can get cloudy when you start venturing into things like factor funds (value, quality, momentum, etc.). A fund can be passive/quant managed, but still be active in the traditional sense. It depends on how you look at the world and how far you’re willing to venture out away from the broad markets.

  3. 10 Monday AM Reads | The Big Picture commented on Sep 21

    […] Funds Are Nothing Special (A Wealth of Common Sense) see also Smart Beta’s Takeover (Chief Investment Officer) • Dear Apple: I may rob your […]

  4. Bob Carlson » Interesting Thoughts on Index Funds commented on Sep 21

    […] been disappointed with most debates over active versus passive investing (or index investing). This post presents many thoughts with which I agree. Investors should know that index investing isn’t […]

  5. Kathy Waite commented on Oct 05

    My issue is that 99% of investors who go to the banks or insurance company distribution channels never get offered anything BUT active. Slick sales materials and building fund managers up as gods prevails. The education starts at which one of our products is suitable for you NOT there are a number of solutions including active, passive etc which is best for you and then how do you implement it in the cheapest simplest way.
    Kathy Waite Regina Saskatchewan Your Net Worth Manager fee only planner. http://www.yournwm.ca