4 Irrational Arguments Against Investing in Index Funds
Chapter 37 of The Rational Investor
This is the last chapter of the book and I am so excited to announce that The Rational Investor is hitting bookshelves one week from today, October 3rd. Click here to preorder the eBook version of the book
Chapter 36: 4 Irrational Arguments Against Investing in Index Funds
The evidence presented in this book has painted a clear road map for the rational investor. Invest in low-cost index funds that buy the entire stock market, and basically forget about your portfolio until retirement.
Unfortunately, most investing resources you will come across will not take the rational approach. An entire media and online ecosystem have sprung up to use narratives and guruism to convince investors to do anything other than buying and holding index funds for 40+ years.
I thought it only fitting that we end our journey with a discussion of four irrational and common anti-indexing narratives you will likely hear.
#1 — The market is not efficient, so there is plenty of opportunities for active management to outperform
Market efficiency refers to the theory first put forward by Eugine Fama from the University of Chicago, which states in an efficient market, all publically available information is reflected in the current price of a stock.
No stock market is perfectly efficient, but the stock market is efficient enough that investors are better off assuming it is.
If the market is decidedly inefficient, then we should expect actively managed funds to outperform their benchmark index on a consistent basis.
Luckily we can measure this as Standard & Poor's keeps a "Scorecard" that measures how actively managed investment funds perform compared to the local stock market index. At the time I write this, over the past 10-years: 83% of U.S fund managers underperformed the S&P 500.
83% of Wall Street managers who have an army of analysts and research at their disposal and whose entire career is centered around beating the market can't do it. But financial bloggers want you to believe they can teach you how to do it.
Another variation of this argument I still hear all the time is "sure, the U.S market is fairly efficient, but foreign markets are less efficient, and that provides an opportunity for active managers to outperform."
Luckily we have that scorecard too. As we covered in chapter 3, here is the percentage of active fund managers around the world that underperform their local benchmark index over the past decade.
83% of Canadian funds underperformed the TSX
85% of European funds underperformed the S&P Europe 350
84% of Australian funds underperformed the
84% of Australian funds underperformed the
84% of Japanese funds underperformed the
This narrative is right about one thing; these fund managers have all the opportunity in the world to outperform, and they consistently fail to do so.
#2 — Index funds own all the "losers"
Yes, a lot of companies that an index investor owns are underperforming companies.
Active funds hold plenty of losers, too, as many actively managed funds are little more than "closet index funds." These are funds that charge high investment fees but more or less track the market in a similar fashion to index funds.
More to the point, it does not matter if an investment fund holds "the losers." As we covered in chapter 9, the only way to guarantee success as an investor is to hold "the winners," the 4% of stocks that are responsible for 100% of the gains in the (U.S) stock market since 1926.
The only way to guarantee that you own the future winners is to own everything all the time. That 83% of underperforming active fund managers think they can select the winners in advance, but they do not have a crystal ball.
#3 — Index funds don't protect your "downside"
This is factually correct.
Index funds do not protect your "downside." If the stock market goes down 40% and you own the entire stock market, your portfolio is also going down 40% — assuming you are 100% invested in stocks. Which, for most people, does not make sense.
This is why we diversify by geography (owning domestic & foreign equity index funds) and by asset class (mainly bonds.)
Active managers try and cushion against a crash by holding a certain percentage of the portfolio in cash. But here's the thing, there's nothing stopping an investor from holding cash in a savings account and receiving some interest rather than paying a Wall Street manager 2% per year to sit on cash.
When active funds hold cash, they underperform in years when the stock market goes up, which is most years.
The data is pretty mixed on whether active mutual funds provide any type of downside protection from a market crash.
A 2020 paper written by Lubos Pastor and Blair Vorsatz titled "Mutual Fund Performance & Fund Flows During the COVID-19 Crisis" found that the majority of active fund managers underperformed their benchmark index during the market crash of 2020. 1
Active managers failed to "protect the downside" when it mattered most.
You might say, "how could anyone have seen something like COVID-19 coming ahead of time?" That might be the single best endorsement of index funds I could think of.
Rational, long-term investors must simply accept that not every year is going to be amazing in the stock market.
#4 — You get what you pay for. Low fees=low quality
This is a narrative often put forward by financial advisors whose clients have educated themselves and fire the advisor to self-manage a simple portfolio of index funds.
This is the funniest and most self-serving argument against index funds.
What makes it funny is that it is the exact opposite of the truth. Research from Morningstar found that investment fees are the number one predictor of future performance.2 The lower the fees, the higher the expected return for investors.
A more accurate statement would be that active fund investors "don't get what they pay for."
What makes this argument self-serving is that when a financial advisor uses a line like this to try and retain a client, it's purely to the benefit of the advisor and often to the detriment of the investor/client.
There is evidence that financial advisors believe in the high-cost mutual funds they are paid to sell.
A 2018 paper written by Linnainmaa Et al. titled "The Misguided Beliefs of Financial Advisors" found that most financial advisors sampled in Canada invest their own money in the same way they invest their client's money.3
Which is to say, they invest irrationally.
Chasing past returns
Investing in high-fee funds
Here's the key finding from the paper "Advisors' net returns of −3% per year are similar to their clients' net returns."
They also found that the advisors who invest this way continue to do so after they leave the industry, indicating this is more than a show for clients but that they actually believe this is the rational way to invest.
The rational approach is clear
No investment strategy is perfect, and future returns of the stock market are not guaranteed.
The best we can do is invest based on the best available evidence. The evidence is quite clear; the rational approach to investing is to buy and hand full of low-cost index funds, diversify by geography and asset class and hold those investments for several decades regardless of what narrative is dominating the financial news cycle.
Pastor, L., & Vorsatz, M. B. (2020, July 1). Mutual Fund Performance and Flows During the COVID-19 Crisis. National Bureau of Economic Research. https://www.nber.org/papers/w27551
Kinnel, R. (n.d.). How Fund Fees are the Best Predictor of Returns. Morningstar UK. Retrieved June 8, 2022, from https://www.morningstar.co.uk/uk/news/149421/how-fund-fees-are-the-best-predictor-of-returns.aspx
Linnainmaa, J. T., Melzer, B., & Previtero, A. (2018, May 16). The Misguided Beliefs of Financial Advisors. Papers.ssrn.com. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3101426