Morningstar Magazine - August/September 2017 - 14
Dispatches
it doesn't compensate for that shortfall by having
lower risk than does the Wilshire 5000.
The Real World
However, the comparison is flawed because
investors can't buy the Wilshire 5000. Nobody can,
not even the largest and most sophisticated of
institutions. Those seeking broad U.S. stock
market exposure can select Vanguard Total Stock
Market Index, or they can select a rival fund. The
real question, therefore, is not whether this
fund can beat a theoretical construct, but instead
whether it beats the living, breathing funds
(so to speak) that investors can purchase.
And we know how that turned out: As the second
graph in the exhibit shows, the results have
outdone even the index enthusiasts' expectations.
Now we see the true case for indexing. Vanguard
Total Stock Market Index's Admiral share
class has beaten its group average (which includes
other index funds as well as actively run
competitors) in 14 of the past 15 calendar years.
Those victories have been substantially larger than
the trivial amounts by which the fund lagged
the Wilshire 5000. That is, not only did switching
comparisons from the index to the category
average make the question relevant, it also made
the answer more meaningful.
Making the fund's triumph even more impressive
is that in 2007, the only occasion on which it lost
to the category average, it beat its typical
rival. A few conservatively positioned competitors
performed much better than most when
the market crashed, thereby pulling up the mean.
However, the fund placed above the median,
landing in the 47th percentile for the year.
Indexing's Lessons
This may all seem rather obvious; today, it is
commonly recognized that for the major index funds,
the advantages of having lower costs
and being fully, consistently invested outweigh the
minor imperfections that are introduced by
implementing the strategy. However, the lessons
are timeless and, I think, not as widely known.
1 Much investment "common sense" is not.
By definition, index funds are losers, because
they can't beat the indexes that they track.
You can't beat the averages by being average.
You get what you pay for. Automated
strategies work great during bear markets, but
when the times get tough, you need a human
hand. All common sense, right?
Not so. Yes, those sentences each sound
reasonable upon their first hearing, and if not
examined too closely. I have heard each
of them delivered at investment conferences,
multiple times, generally with great success. The
audience nodded appreciatively; there were
few if any murmurs in protest, and no awkward
questions posed to the speakers.
Yet each bromide is wrong. As we saw, index
funds are indeed by definition losers, but
that definition happens to be unimportant. That
something happens to be true doesn't make
it significant. As for the notion that index funds
can't beat the average by being average, that
claim relies on the listener misunderstanding the
facts. Index funds are average (or close to)
before expenses are subtracted, but they are
above average afterward.
As Jack Bogle likes to point out, investments differ
from other consumer purchases in that you
don't get what you pay for. Instead, you get what
you don't pay for, because every penny of
expenses comes straight from a fund's returns.
Finally, while it seems reasonable that tough
times require a human hand, there's no evidence
from multiple bear markets that investment
managers can identify bear markets before they
occur and profit from that knowledge.
Morningstar August/September 2017
Speaking of which, Renaud de Planta, managing
partner of a European asset-management
firm, recently wrote that if most investors embrace
passive investments, "index-trackers threaten
to sabotage the entire economic system. Much like
antibiotics, if passive funds are overused,
they will create more problems than they solve."3
That comparison seems ... a stretch.
3 Misperceptions can and do persist for a long time.
It required 80 years for the effect of mutual fund
expenses to be fully appreciated. Mutual funds
first came to prominence in the 1920s, but
it wasn't until the mid-2000s that low-cost funds
consistently outsold high-cost funds. (Today,
almost every new fund share carries significantly
below-average expenses.) Even indexing took 20
years to move from the fringe to the mainstream.
In short, the mutual fund industry remains
something of a story business. It is less so than
most other financial offerings, such as
hedge funds or insurance products, which are less
transparent. It is also less so than in the past,
thanks to decades' worth of evidence and
extensive academic and industry research. But it
remains an industry where stories are told-
stories that sound convincing on the surface,
and that may well convince those who tell them,
but which cannot withstand close analysis.
2 Expedience is a powerful force.
Listener beware. K
All right, you probably knew that part, too. Before
Caesar and Christ were born, Demosthenes
wrote that the easiest mistake is self-deceit,
because man believes what he wishes to be true.
That belief is particularly strong when it pays
3 De Planta, R. 2017. "The Hidden Dangers of Passive Investing," Financial Times, May 30.
14
in cash. Active portfolio managers are, on
the whole, very bright people, and probably more
ethical than most employees in most industries
(my readers, of course, being happy exceptions).
But they are severely compromised when
discussing the demerits of index strategies. I am
constantly surprised that their comments receive
the attention that they do.
John Rekenthaler is vice president of research
with Morningstar Research Services.
Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017
Contents
Morningstar Magazine - August/September 2017 - Cover1
Morningstar Magazine - August/September 2017 - Cover2
Morningstar Magazine - August/September 2017 - 1
Morningstar Magazine - August/September 2017 - 2
Morningstar Magazine - August/September 2017 - Contents
Morningstar Magazine - August/September 2017 - 4
Morningstar Magazine - August/September 2017 - 5
Morningstar Magazine - August/September 2017 - 6
Morningstar Magazine - August/September 2017 - 7
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Morningstar Magazine - August/September 2017 - Cover3
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Morningstar Magazine - August/September 2017 - Cover1I
Morningstar Magazine - August/September 2017 - Cover2I
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Morningstar Magazine - August/September 2017 - Cover3I
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