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THOSE OF US WHO GREW up in the 1950s watched Howdy Doody on that large, newfangled box with a picture tube and knobs. The show’s host was Buffalo Bob, who enthusiastically proclaimed Wonder Bread “helps build strong bodies eight ways.”
Subsequent nutritional research debunked that claim, and the government induced Continental Baking to add back the healthful ingredients that its processing methods were removing. The new wrapper proclaimed “enriched” Wonder Bread, even though the firm was simply replacing what had been there before.
That brings me to investing. Instead of Howdy Doody, many of us now watch CNBC, where talking heads expound on the virtues of picking stocks and making market bets. Does such active involvement help strengthen our portfolios eight ways? Consider these eight dubious contentions from fans of active management:
1. Index funds produce average—and hence unsatisfactory—returns.
Remember the game show Who Wants to Be a Millionaire? If your goal is seven figures, start making steady monthly contributions to a broad stock market index fund when you’re young. Live your life, pursue your dreams and don’t mess with your portfolio’s compounding. By the time you reach retirement age, there’s a good chance you’ll have your wish. How’s that for average?
2. Results for most index funds diverge from their underlying indexes.
Consider one of the most popular exchange-traded index funds, Vanguard Group’s S&P 500 ETF (symbol: VOO). In 2021’s soaring market, the Vanguard fund’s 28.6% total return was virtually identical to the index’s 28.7%. In last year’s tumultuous down market, the corresponding figures were -18.2% and -18.1%. What divergence are they talking about?
3. The higher cost of active funds is insignificant.
We can quickly dispense with this blatant untruth. Research has linked higher expense ratios to lower fund returns, and the longer the time horizon, the greater the impact. Suppose you invested $100,000 at a modest 4% a year—before costs. Over 20 years, you’ll end up with almost $10,000 more if you pay 0.25% in annual expenses rather than 0.5%. And, of course, most active funds charge far more than 0.5%.
4. Money managers’ massive research capability gives them a big leg up on index investing.
What leg up? It’s the outrageous cost of that research albatross that explains much of why portfolio managers consistently underperform.
5. Active funds protect investors by shifting in and out of market sectors and moving between stocks and cash.
What good is all that activity if active managers have no proven skill in the first place? On top of that, investors shouldn’t have to pay a fee for that part of a stock fund that sits in cash. We’re perfectly capable of hoarding our own cash.
6. Active managers can exploit market inefficiencies among small-cap stocks and emerging markets.
Here we can consult the last word on active vs. passive fund performance, the S&P Dow Jones Indices’ SPIVA report. In 2021’s rising market, 71% of active small-cap funds failed to beat their index bogey. Likewise, in 2021, 65% of active managers underperformed when trying to pick among emerging markets’ less followed and less liquid stocks. What about last year’s tumbling market? In the just released 2022 data, active funds succumbed 57% of the time among small stocks and 76% in emerging markets.
7. Directionless and choppy markets offer special opportunities for stock pickers.
I can’t turn up any evidence to counter or support this claim. Andrew Marchant, chief investment officer at financial advisors Minchin Moore, refers to the stock-picker story as a “nice idea that has no grounding in actual fact.” Given the inability of portfolio managers to perform well in up and down years, it seems highly unlikely they have a hidden talent for plucking promising stocks from a directionless market.
8. Actively managed funds have consistently outperformed their corresponding benchmarks.
Are they kidding me? Let’s get real by going back to that definitive SPIVA report. In 2021, just 20% of all active U.S. stock funds outpaced the S&P Composite 1500 Index. Active managers’ results “improved” to 50% in 2022, their best showing since 2013. But it’s the long-run results that are truly telling. More than 92% of U.S. stock funds have failed to beat the index over the past 20 years. Adjusted for volatility, that figure rises to an unconscionable 97%.
Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.
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I understand the simplicity and power of indexing. In general, indexing is a straightforward approach when faced with the daunting task of picking the best investment. However, I would posit that indexing makes most sense in taxable accounts since indexing creates less in taxable events. In tax-advantaged accounts, you are free to invest in managed or indexed investments.
With managed mutual funds, for instance, compare total returns with the benchmark index. Only pick funds that consistently exceed the benchmark index in 3/5/10 yr – shorter timeframes are noise. That will whittle down the list considerably as statistically shown in this article. Further reduce the list to eliminate funds with loads, transaction fees, and marketing fees.
When a fund loses that edge over the index, you replace the fund. If you made the initial assessment carefully, you will not be churning since you picked a consistent winner and not the latest unicorn that will revert to the mean.
Not as simplistic as invest-and-forget, but well-managed funds have a place in an investment portfolio with just a wee bit more effort in my opinion (mostly in the initial investment stage). The extra returns are worth it until simplicity rules all as you age in retirement.
As an active fund investor let’s take a look at the end process of our adventure with $. My objective was to accumulate assets and then spend those assets in retirement. Now I selected 5 funds, two of which I have invested with for decades, 3 I don’t invest with but my father did before he died. The funds are well known and large in assets. I selected the S&P 500 as the Index to compare with.
Assume we use the withdrawal method of 4% initial and increasing by 3% annually. Assume my funds and the S&P begin with $100,000 each–we begin on 01/01/2000 and we go up to the end of March 2023. We have two big bear markets and in 2020 a quick loss of 33% because of covid.
We withdraw a total of $131,127.00 during this period and the ending values, as of last month, varied from a high of $211,000 to a low of $120,180.00. The Index was worth $12,741, thus let’s bet on when it runs out money. I selected funds that invested in U.S companies so as to mimic the index . I used all the equity funds they had so as not to cherry pick.
Now, my particular fund had the highest ending value because, for 70+ years, it has invested in U.S. blue chips that pay dividends and has a standard deviation far less than the growth funds and the index. Minimizing volatility with a withdrawal program can be very beneficial.
Assume in 1970 we invested in the funds selected and the Index. All the funds beat the index even after a 3.50% load was administered so one had more $ to begin with when withdrawing for hopefully another 30-years. Seemingly I have a slim chance of running out $, unless I owned the Index.
This is not an anti-index screed just some food for thought. The first goal is to accumulate the assets–2nd goal is the distribution. Looking at past returns can help make an informed choice. For millions the index works just fine–for those like me I chose a different path.
I did retire in January of 2000 so it looks like a withdrawal program from the most popular index at that time in the equity sphere would not have worked well for me.
Active managers (and active mutual funds) can beat the market, but the dilemma for investors is that we will never know which active manager will beat the market going forward.
Steve, thank you for your posting. It’s spot on.
There is a recently published book titled “Shut Up & Keep Talking” by Bob Pisani, the Senior Markets Correspondent for CNBC. Bob has covered the stock market from the floor of the New York Stock Exchange for 25 years and, over that time, he has interviewed many of the movers and shakers of Wall Street. He has covered the global stock market, IPOs, ETFs, and financial market structure for CNBC.
You would think that with such experience, the author would know better than most how to pick winning stocks or money managers. Yet, in one refreshingly candid chapter, he reveals that his own portfolio consists of Vanguard index funds. Imagine that!
Thanks Steve for another great article! About 15 years ago I used to watch CNBC, but rarely take a peek at it anymore. It took me a while to figure out the hyperbole and thinking that fairy dust was good.
Hi Olin
Sorry so late in getting back to you. How’s this for “breaking news?” “Dow looking at 1 down day of last 2”
Bogle said over 40yrs in a taxable account, a 10% versus 8% results in a 77% loss of wealth- The Tyranny of Compounding he coined it
Ignoring taxes, in a tax deferred account, a 10% annualized return on a fixed lump sum investment over 40 years would return (1.10)^40= 45.26 If you were charged an annual 1% AUM fee, then (1.10 X 0.99)^40 = 30.28 and if you were charged 2% then (1.10 X 0.98)^40 = 20.17, which is 55.4% less. While our numbers are a bit different, it does indeed show the power of compounding, in this case, the negative compounding effect of fees! Your quote is an excellent reminder to all of us that compounding over time can be wonderful for our gains, but not so much if we are paying fees, which is why his quest to charge us rock bottom fees was so fair and generous!
Part of the tyrant of compounding is its insistence we not indulge in those small but cumulative disadvantages, like high cost, high tax (and large spreads), that limit its power.
I enjoyed reading your debunking of many mythical claims, and your prior posts as well. Statistics and probability are beautiful tools, when used correctly. I feel as though I’m inundated with statistics. It’s a rare newscast that doesn’t include statistics, and this is especially true for televised sporting events. Most index fund investors are well aware of the difference between average stock market performance and average investor performance. I suspect many or most readers on Humble Dollar are familiar with the bet Buffett made in 2008 that a single lump sum investment in Vanguard’s S&P 500 Admiral fund would outperform a diverse group of hedge funds, selected in advance by Protege, an investment advisor, over a ten year period. The hedge funds included five “funds of funds” (over 200 in total) and their 10 year annualized returns were: 2.0%, 3.6%, 6.5%, 0.3%, and 2.4%. The index fund notched 8.5%. Details are included in his 2017 annual letter.
His point of course was that fees matter. I have no doubt that there are a small number of investors who will outperform the market, but I have no idea who they are. I am content to “settle for average”, the average gains of the market as a whole that is.
Hi Jack,
Another terrific comment. Settling for average is such a misleading way to describe the results of index fund investing. It may be average in relation to unrepeatable outlier performance, but it’s really the most efficient and easily accessible way for most people to harness the fruits of economic growth and the power of compounding to achieve long-range goals.
I am fortunate that I discovered Vanguard many years ago, and have never, as best I remember, ever watched CNBC.
I’m not sure why you are using 0.25% as the low end for annual fees. Vanguard tells me the costs for my total portfolio are 0.10%, and that’s probably on the high end. The expense ratio for the VOO ETF you reference is 0.03%. And of course AUM fees are much worse.
Hi mytime
I see where I might have confused you. The .25% was just the example used inn my source, and it obviously doesn’t apply to Vanguard. No worries, the numbers you cite are correct.
I know my numbers are correct, I checked them. I was pointing out that your argument would have been stronger if you had used more realistic numbers. The .25% is much higher than necessary. Perhaps you need a better source, although the math is straightforward.
Anyone who has read Malkiel or Bogle knows Indexing is the winning long term strategy. All others are a distant second. A few yrs ago index funds took over the majority and have more assets than active funds. Americans are getting the point that trying to beat the Indexes is a fools game. As Buffett says, When everyone is fearful be greedy
Hi Kenneth
We even neglected to mention one of Malkiel’s favorite topics—the tax advantages that go along with the very low or entire absence of capital gains.
I think the problem with active managed funds is the investors, not the managers.
When the stock market is booming, the money pours into the fund, but when the market is going down, withdrawals are the norm. The fund managers know perfectly well they should be buying at the lows, and selling when the market goes crazy, but the flow of funds forces them to do the exact opposite.
Of course, this does not apply to individual investors. You are free to buy when stock prices hit new lows, and sit on your hands when the market is soaring – if you have what it takes to go against the crowd.
I’ve heard this point made many times over the years. That individual stock pickers aren’t like active fund managers, having more freedom to make their selections because they are not beholden to a pool of investors. Whether active fund managers are significantly handicapped compared to individual stock pickers, I have no idea. But I’d love to know the true long-term performance of individual stock pickers doing their own research and picking their own stocks.
To be fair, it’s easy to find research that shows long-term indexing beats active mutual funds. I’d love to see research from some of the largest investment management firms which analyzes the performance of individuals and the stock selections they’ve made. It’s possible that such research exists, but I haven’t found it other than articles that say something like, “research shows individual stock picking lags the market” or something similar that just says active investing.
Hi Brent
Great comment! Let me suggest an excellent 5 min. read that might be helpful. It covers everything from Fama and the efficient market hypothesis to the embarrassing results relative to historical t-bill investing. It’s “Picking Stocks is a Loser’s Game,” by Ben La Fort, 2019.
Here’s a link to the piece:
https://themakingofamillionaire.com/picking-stocks-is-a-losing-game-f21f2388b06d
Thanks for the above comments referencing and linking to the article.
Nice article, thanks. particularly liked: “Translation; picking stocks introduces additional risk without increasing your expected return. There is no rational basis for investing this way.” and “4% of U.S stocks accounted for 100% of the gains in the U.S stock market since 1926.”
Hi Ormode
I like your diagnosis, very reflective of extensive research conducted by Morningstar. But I’m less enamored with your solution. Many investors in active funds (or their advisors) have already decided against individual stocks as requiring too much research, sophistication and time. Very few of us have the ability to make two critical decisions—when to enter and when to exit. For most people who become disappointed in their active fund performance, a far simpler and usually more productive alternative is the index mutual fund or ETF.