Should You Lower Fees and Index?

Should You Lower Fees and Index?

The popularity of indexing has never been stronger after a banner year for US stocks in which indexed stock funds outperformed most actively managed funds. This raises an obvious question: Should investors put all their money in index funds and dispense with managers’ fees?  The data clearly shows that indexing beats active management, and Vanguard’s website has research to back this up.

Seems like it’s a no brainer to index! Or is it?

Before addressing this question, it is important for you to know that Highland utilizes both passive (indexing) and active investing strategies, and does not have an incentive to use one over the other.  Our firm is independent, has no proprietary products, and could fill every asset class with index funds if desired.  I mention this because many people in this business fall prey to Upton Sinclair’s famous quote, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

Data can be easily manipulated to tell the story you want it to tell.  Politicians do this frequently, and it happens all the time in the investment industry, too.  Whenever you look at studies, claims, or marketing pitches, always consider the source and what that source stands to gain or lose.

The money management business has a justifiably bad reputation, making indexing an even more appealing option…but it’s important not to throw the baby out with the bathwater. 

As someone who spends lots of time filtering the noise, here are my thoughts:

  • Index funds or ETFs generally outperform active managers before and after taxes.  This is true in most market cycles, even bear markets.  The primary reasons are fees and tax efficiency.  
  • 30-40% of active managers are closet indexers, meaning their portfolios are eerily similar to the index.  These expensive “index funds in disguise” almost always under-perform and should be avoided.  If you exclude them, the remaining active managers look much better.
  • Large firms with many funds often aren’t aligned with their investors.  Why?  Some of their funds will do great, just by pure chance.  Fund companies can market those winners aggressively and shut down the losers.  From the company’s perspective, it wins either way.  Smaller shops with just a handful of funds are more vested in getting it right.
  • The best candidates for indexing are U.S. large- and mid-cap value funds and international developed funds. The active managers that outperform don’t beat the index by very much and have low persistence (meaning they typically don’t repeat their performance).
  • Active small-cap, emerging markets, and REIT managers that outperform indexes tend to outperform materially and have high persistence, meaning they tend to stay on top.
  • Many truly active managers have outperformed sizably after fees are factored in.
  • Fees are a very important consideration when choosing investment vehicles, but they are just one factor. Many people are seduced by low fees and place too much emphasis on this.

The Problems with Indexing

Theoretically, the success of indexing can be a self-fulfilling prophecy that depends on more and more investors deciding to index.  By design, the popularity of indexing manipulates values without considering valuation.  For example, from 1990 to 2005, stocks being added to an index went up about 9% around the time they were added to the index, even though nothing fundamentally changed in their businesses.

During the late 90’s, buying an index meant buying piles of ridiculously valued internet stocks that eventually crashed, which speaks to the problems of capitalization-weighted indexes.  In the depths of the Great Recession of 2008/2009, all of the news stories were about how “buy-and-hold” and indexing strategies were dead.  This led to indiscriminate selling, and the S&P 500 index dropping 57% from its peak as a result. Today, buying an aggregate bond index fund means that you’re heavily weighted in government bonds that may be about to burst after benefiting from a 30-year trend of downward interest rates. These scenarios illustrate some of the greatest weaknesses of indexing as a stand-alone strategy: lack of downside protection and emotionally-driven investment decision making.

Looking at the Bigger Picture

Indexing typically works best during an extended bull market.  However, active management with a real focus on downside protection can work much better during sideways and bear markets.  Here’s why: if you lose less when the market declines, you don’t have to earn as much back to recover.  For example, if you lose 50%, you have to make 100% just to break even.  If the loss is 25%, you only have to make back 33%, and anything beyond that is profit.

Of course, reducing the downside means sacrificing some upside, but this isn’t problematic during an extended period of high volatility like we have experienced since 2000. Many people fail to realize that compounding works much better when volatility is lower.  This article shows how lower beta stocks (less volatile than the overall market) do better over time than their higher beta cousins.

Now, an active equity manager isn’t going to be able to offer this kind of downside protection. To materially limit downside while still leaving room for good upside in their portfolios, investors must incorporate many different segments and flavors of active and passive (index) funds across fixed income, equities, real assets, and hedge funds.

What to Do?

When valuations are low and markets have sold off dramatically, indexing can be an easy, cheap way to gain market exposure if you’re patient enough to wait for the ride up.  However, in today’s market when valuations are stretched and the S&P 500 has run up more than 170% since the bottom in 2009, it can pay off to be more active with your investments, even if that means just moving to a less risky index. 

Interestingly, this is when many investors throw in the towel on active management and decide to index everything.  In early 2009 when the market was down more than 50%, many investors abandoned index investing to be much more active because it felt like the right thing to do.  This was the exact opposite of what one should have done. 

I think it’s easy to get caught up in the simplicity of indexing or the allure of active management.  The reality is both active and passive investments have their place in a portfolio.  Even if you decide to index everything, you have to pick which indexes you’re going to use.  For example, should you use fundamental indexes or cap-weighted indexes?  How much should you allocate to each asset class?  Another consideration is the time frame over which you are measuring the effectiveness of either approach.  By looking at the empirical evidence, paying attention to valuations, constructing a well-balanced portfolio, following process, and taking emotions out of the equation, you are likely to achieve much better results.

 

Ben Johnson
ben@highlandprivate.com
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