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Why Index Funds are Killing Active Funds

     The video above starts with the well known Sun Tzu "The Art of War" clip from the 1987 movie "Wall Street" where Michael Douglas playing Gorden Gekko is lecturing Charlie Sheen's character Bud Fox. That scene has some really interesting language and in this article and embedded video I'm going to offer my explanation of why "index funds are killing actively managed funds." I'm not saying Gordon Gekko was wrong regarding his statement implying that portfolio managers are sheep that follow the herd, but that's not the primary reason managers underperform indexes and index funds.

     The language for the title of this video and article is actually from David O'Leary who was quoted 22 years ago in a 1997 article in the Los Angeles Times. The quote reads "There is a crisis in the industry--not just at Fidelity--in that index funds are killing the actively managed funds." I recently rediscovered that quote on a web page that I posted in 1997 titled "The Magic Number." In 1997 I started blogging about what we can call the hunt by the Vanguard S&P 500 Index fund in pursuit of Fidelity's Magellan fund for the title of the largest mutual fund, and I was really writing about the broader significance of that event. I wrote then, "like it or not (and there are a lot of people in the investment business who won't like it), if and when the 500 Portfolio passes Magellan, it will be a historic event for the mutual fund industry."

     The Vanguard 500 Index Fund was originally introduced in 1976 and in fact it started slowly, and it wasn't until 1995 that the fund passed the $10 billion mark in assets. I blogged about that race for about three years and The Vanguard Index Fund officially passed Magellan in April 2000 when it had $104.8 Billion in assets versus Fidelity Magellan Funds $104.6 Billion.

     By the end of 2018, Vanguard not only had the largest mutual fund, they managed the three largest U.S. stock mutual funds and the three largest U.S. bond funds, according to the Wall Street Journal's year end list of largest mutual stock and bond funds. While some initially called the fund "Bogle's Folly", Jack Bogle got the last laugh and millions of investors have benefitted from his work.

     This topic is also timely because in September of 2019 John Gittelsohn at Bloomberg reported in an article titled "End of Era: Passive Equity Funds Surpass Active in Epic Shift" that based on Morningstar's data, passive US index equity fund assets exceeded active equity fund assets as of the end of August 2019 ($4.271 trillion compared with $4.246 trillion).

     There really isn't a lack of active funds. There are thousands of active funds and active managers and there probably always will be many active managers, but as you can see in this chart from the Investment Company Institute, index mutual funds and ETFs have been growing rapidly, while active mutual funds have been steadily losing assets. Given the trend and massive increase in the use of passive funds, the comment about killing refers more to performance than actually eliminating active funds.


Source: ICI

     In general

The numbers depend on several factors including the expected returns, and volatility or standard deviation, but usually the most relevant factor is the active manager's cost. The higher the cost differential between active managers and index funds, the higher the active managers probability of underperformance. (See this page or The Peaceful Investor for further discussions on this topic.)

     The explanation why index funds outperform and kill active funds is actually simple mathematics and logic. Indexing an asset class, for instance buying the entire US stock market, or the global stock market, effectively allows to you disentangle (or separate) the investment activity in buying stocks from the speculation inherent in trying to beat the market in specific stocks, or funds, or strategies. So in simple language, indexing effectively allows an investor to separate investing from speculating.

     This is not my original idea or explanation. There are no universally accepted definitions of "investment" and "speculation" but I refer to an article that Martin Fridson published in the Fall 1993 issue of the Journal of Portfolio Management titled "Exactly What Do You Mean By Speculation?" Fridson summarized and listed definitions and Fridson proposed the term "subdiversification" by defining investment in the context of modern portfolio theory and diversification.

Subdiversification: Ownership of a mix of assets other than a fully diversified, market-weighted portfolio.
Speculation: Subdiversification with the intention of earning a superior risk-adjusted return.

     Before 1976 when Jack Bogle and others created index funds, you could really only buy individual stocks, or mutual funds, or closed end funds. Let's say you buy a single stock. Every year some stocks multiply, but others go bankrupt. In other words, if you invest in one stock you could multiple your money or you could lose it all. You effectively have a lot of variability. But if you buy the market through an index fund you would have gotten less variability. Historically US stocks have returned about 9%, or 6.6% above inflation and 3-4% above the return of the risk free asset or US Government Bill/Bond (according to Jeremy Siegel and others). The premium above the risk free bond is known as the equity risk premium (see global data from Elroy Dimson, Paul Marsh, Mike Staunton).

     Rick Ferri has also summarized that active investing is "uncompensated risk." In other words, an active investor is taking risk by deviating from the broad index, and rather than increasing expected returns and odds of beating the index, the higher the costs, the lower the expected return.

     Nobel laureate Paul Samuelson is credited with the idea of the index fund. In a 2005 speech Samuelson ranked Jack Bogle's index fund "invention along with the invention of the wheel, the alphabet, Gutenberg printing, and wine and cheese." The creation of index funds in the investment business was a game changer, and it is the analogous to the creation of a better mouse trap.

     Returning to the clip from the movie Wall Street, ironically, the Sun Tzu argument that every war is won or lost before its fought is actually quite applicable to the battle between passive and active managers. It is actually decided before it starts because mathematically, passive investors always beat active investors in aggregate, when measured correctly. Yes, some managers beat the indexes, but that's not the question. The question is whether the average active manager and the aggregate of active managers can beat an appropriately measured passive fund or index. And the answer to that question is no. The proof of this was documented by Nobel Laureate Bill Sharpe in his paper "The Arithmetic of Active Management."

     Regarding the "managers are sheep and sheep get slaughtered" quote, there is some truth to that and I document much of the relevance in Chapter 11 and other sections of The Peaceful Investor where I discuss bad timing and herd behavior among both individual investors, advisors, and institutional investors. This discussion also leads into other discussions like risk factors and anomalies, for instance like value investing, and you might notice I didn't mention market efficiency. That's because whether the market is completely efficient at pricing doesn't significantly affect the mathematics of active management. Will some funds and investors beat the market? Of course, some will beat the market. But the longer the time frame and the higher the costs incurred in the active management process, the greater the underperformance of the active investors as a group, and the worse the odds of outperformance get.

     So what does all this mean for investors? It means the default for investing in a broad asset class (as opposed to a specific investment) is usually a low cost, low turnover index fund, because it helps you minimize costs (and taxes) and maximizes your expected return for that asset class. Again, the key takeaway is index funds are killing active managers and funds because indexing is a tool that allows investors to effectively disentangle investing from speculating. Those that choose active management over passive management are likely to reduce their returns by the amount of the additional costs incurred and possibly increase their risk in the process.

Gary Karz, CFA
Author of The Peaceful Investor and Publisher of InvestorHome.com
twitter.com/GKarz (email)


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