For some time now, actively managed mutual funds have been underperforming index funds that essentially own shares of all the stocks in the market. That’s because the lower costs of index funds give them huge advantages over the high-priced active funds. Though I’ve been investing in index funds for decades, I’m rather surprised by their more recent popularity. My indexing approach was once rare, but now a full 37 percent of the money in U.S. stock funds is in index funds. With more and more money flowing out of managed funds and into index funds, can indexing become too big?
Many people have come to me worried that indexing is, or will soon become, too big. They point to two reasons for concern. The first is that index funds now cause individual stocks to move together because the largest index funds own every stock. The second is that markets are becoming inefficient because fewer managers are working to determine whether stocks are over- or undervalued. Let’s examine each.
Indexing causes stocks to move together
This argument supposes there was a time when owning a couple of dozen stocks provided diversification, as some would move up while others would decline. These days, indexing has allegedly changed that since so much money is in funds that own every stock.
Rick Ferri, founder of Portfolio Solutions, points to the dispersion of stocks in the market. Dispersion tells us by how much the return of the average stock differs from the market average. Ferri notes that dispersion today is not significantly different than in the 1990s, when indexing had a tiny market share (dispersion chart of the S&P 500).
And, logically, if an index fund rarely buys or sells stocks, it should have little impact on the price of any stock. Only new money coming in or being taken from index funds would cause buying or selling of every stock. Though true that indexing is capturing share, it still accounts for a tiny fraction of daily trading in stocks.
Indexing causes markets to become inefficient
If everyone indexed, then no one would ever buy or sell a stock. Apple could come out with a great product and no one would drive the price up. Conversely, BP could have an oil rig disaster and no one would sell to drive the price down. Although this all may be true in theory, it’s not in reality. If it were the case, I would abandon my decades of indexing and become an active investor. How many active investors it takes to keep markets efficient is debatable. Certainly 10 percent of investors could drive stock prices based on market conditions. Financial theorist William Bernstein says, “I’m often asked how many active participants are necessary to maintain market efficiency: ‘Two dentists having lunch in Lubbock.’”
Active investor day
One thing I have changed over the last decade is trying to convince people that indexing is superior to active investing. Maybe it’s because deep down inside — and despite the arguments I just made — I am a bit concerned that indexing is becoming too large.
Today when someone tells me they are beating the market, I respond by congratulating them and telling them to keep doing what they are doing. In fact, I’ve even proposed a national holiday for active investors. Perhaps April 1 is a good day.
Value investing, the art of finding gems among beaten-down stocks, is a time-honored strategy. But recently a simple approach to value has become fashionable: Instead of hunting for bargains, buy all the stocks in the market, but “tilt” so that you own more of those with low prices relative to earnings or underlying business value. Academic research says it earns some extra return, and now lots of mutual funds and ETFs offer such statistical value plays.
So it might surprise you to learn that from 1991 to 2013, investors in value funds underper-formed the S&P 500 by close to a percentage point a year, according to an analysis of fund data by Research Affiliates.
Does this mean the value premium is overhyped?
No, it’s just misunderstood. The same study showed that value funds beat the market by nearly half a percentage point annually over this stretch. But, on average, investors in those funds didn’t capture that edge, because they traded at the wrong times, piling in when the style was hot and selling only after the funds had underperformed. So before you go after the so-called value effect, keep two things in mind.
Value Isn’t a Short-Term Play
Although there’s evidence that value works in the long run, “you can go decades where value is either in or out of favor,” says Gregg Fisher, chief investment officer for Gerstein Fisher. Indeed, growth stocks—the high-priced antithesis to value shares—largely outpaced the broad market from 1988 to 2000.
“The worst thing you can do is try to time value,” says Jason Hsu, vice chairman at Research Affiliates. If you wait to snap up such stocks until after they’ve done well, you lose part of their advantage—the low prices.
Tilt Lightly (Especially Now)
The investment community has lately gone on a tilting spree. Rick Ferri, founder of Portfolio Solutions, warns that there’s “an awful lot of money going into a small group of securities.” And there’s evidence that the market has changed as a result: The stocks with the lowest price/earnings ratios are now only 15% cheaper than those with the highest P/Es. The value discount has been closer to 35% in the past.
Ferri recommends keeping the majority of your stock portfolio in an index fund or something else that’s in line with the broad market, devoting no more than 25% to value or other kinds of tilts. And don’t do it at all unless you expect to be invested for a long time. Says Ferri: “With all this recent attention, it might take 20 or 30 years before you see the true benefits.”
Wall St. Journal
You know all that advice you hear about stock investing? You should ignore most of it. If you're investing for a long-term goal such as retirement, then keeping it simple with a portfolio of three to six broad-based, low-cost mutual funds can pay off in the long run. Rebalance on occasion, and you'll be well on your way. Read the complete story here.
Passive investing guru and Forbes contributor Rick Ferri joins us to talk about a “smart money” strategy that’s cropped up lately: Can you beat the S&P 500 with the S&P 500? His answer may surprise you. Listen to the Podcast here.
Rick Ferri, founder of the investment firm Portfolio Solutions and a known advocate of passive investing, projects that over the next 20 years, the exchange-traded product industry will at least triple the number of funds on the market. Read the complete story here.
The Wall Street Journal
With prices sharply down on many commodities--and stocks at record highs--investors may be wondering: Is it time to swap stocks for soybeans? We investigate. Read the complete story here.
ETF Daily News
It’s well known that the majority of actively managed mutual funds underperform comparable index funds over any period longer than a few years. In fact, that statement has become so uncontroversial that even mutual fund salespeople freely acknowledge it. But a recent white paper co-authored by Rick Ferri, A Case for Index Fund Portfolios, takes this idea a step further. Read the complete story here.
S&P Dow Jones Indexes
Craig Lazzara, Global Head of Index Investment Strategy, S&P Dow Jones Indices interviews Richard A. Ferri, CFA, Founder, Portfolio Solutions LLC. Watch the video here.
What’s the best way to invest your money? I’m not talking about whether to invest in stocks or bonds or real estate. I assume you’ve already decided on a diversified portfolio of mutual funds or ETFs, most likely covering all three of those popular asset classes. The question is: What kind of funds should you choose? Read the complete story here.
Less is more. That's the record message of a recent Wall Street Journal piece encouraging the use of an extremely simple portfolio with a bare minimum of funds. The record is hard to dispute. Passive funds often outperform active funds in annual surveys. And combining passive funds into a simple portfolio beats a portfolio of active funds, as Rick Ferri noted in a recent white paper. Read the complete story here.
Diversification means different things in different contexts. We can speak, for example, of diversification within an equity portfolio — i.e., of holding a number of stocks with potentially-offsetting risks, as opposed to concentrating on only one issue or on a handful of similar stocks. Or we can think of diversification across asset classes — e.g., by adding bonds, or international stocks, or commodities to a (diversified) U.S. equity portfolio. Conventional wisdom smiles on these two forms of diversification, and rightly so, since the final diversified portfolio typically has a higher expected return, or lower expected risk, than the starting portfolio.
But diversification might not always be a good idea.
- See more at: http://www.indexologyblog.com/2013/07/19/when-diversification-fails/#sthash.URPARztH.dpuf