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 involved 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