How more and more indexing via ETFs leads to market fragility, lower diversification and herd behavior, but why most investors should index anyway.
In this episode you’ll learn:
- Why most active managers underperform their designated market benchmarks.
- How big is indexing relative to total stock market capitalization.
- What are closet indexers and tracking error.
- What is the hidden cost of indexing.
- How indexing leads to market fragility, higher volatility, lower diversification and herding behavior.
- Despite its flaws, why most investors should still index.
How To Be An Above Average Investor
The first time I played tennis on my city’s public courts I was nine or ten. I used a wooden racquet ball racquet as I didn’t own a tennis racquet. I won due to superior technology. My friend had used a ping pong paddle.
Five years later, I owned my own racquet and had advanced enough in my tennis skills to play doubles on my high school tennis team as a freshman.
The next year as a sophomore I played first singles, which meant I was our team’s star player; not because I had dramatically improved but because all the better players had graduated.
My season as a singles player was highly predictable. When we played teams from school districts with a higher socioeconomic status than my lower middle class neighborhood, I was soundly beaten, usually by their reserve team. Players at those schools had been taking private lessons for years on indoor courts using regulation size racquets instead of ping pong paddles.
When I played teams from school districts poorer than mine, I won. It was when we played schools that were at our same socioeconomic level that things got interesting.
One of those schools was Reading High School. I looked forward to that mid-season match as a real test of my tennis skills. I was even more excited when we arrived at their courts, and I found out my opponent was a girl.
She was beautiful—long dark hair, brown eyes, tanned skin from sun-filled days of playing tennis, dressed all in white. We were assigned to a court apart from the others about a quarter mile from the main courts.
As we chatted on our walk to the courts, I felt a little bad that I was about to beat such a cute girl in tennis.
Later, after she had soundly beaten me I was glad our court was far away from the others so no one could see I had lost to a girl.
I lost for a very simple reason. I made more mistakes than her.
Amateur Tennis Is A Loser’s Game
Amateur tennis is a loser’s game. Simon Ramo in his book, “Extraordinary Tennis for the Ordinary Tennis Player,” discovered that in amateur tennis 80% of the points are lost. The players hit the ball long or into the net or they double fault on their serve. The outcome is determined by the loser’s mistakes.
In professional tennis, 80% of the points are won by the better player. The outcome is determined by the winner’s superior shot placement.
Investing Is A Loser’s Game
Charles Ellis in his classic investment book, “Winning the Loser’s Game” made a strong case for why investment management has involved from a winner’s game where active stock managers could outperform the market indices to a loser’s game where most trail their designated market benchmarks.
Decades ago the vast majority of stock trades were made by amateur investors. Professional investors could gain an informational advantage over these amateur investors by conducting research on the companies issuing stock. These professionals could determine which stocks were over or undervalued because the market was primarily comprised of investors who didn’t conduct as much research.
Over time, more and more trades were made by institutions and as computing power increased and the cost of technology fell, professional investors got better and better at identifying mispriced securities.
Ellis writes, “As a group, professional money managers are so good that they make it nearly impossible for any one professional to outperform the market they together now dominate.”
This high level competition means very few active managers can outperform the market indices after fees.
Most Managers Underperform
For example, a 2013 study by Nerd Wallet showed only 24% of active U.S. based mutual funds outperformed their designated benchmark for the ten years ending December 31, 2013. The study showed index funds that seek to replicate the market outperformed actively managed funds by 0.8% annually.
Likewise, a study by S&P/Dow Indices found 86% of European based actively managed funds investing in global, U.S. and emerging markets failed to beat their benchmarks for the ten years ending December 31, 2015.
This disappointing performance has led more and more investors to pull money from actively managed funds and allocate it to exchange traded funds (“ETFs”) and index mutual funds that seek to replicate areas of the market rather than try to outperform them.
In 2015, ETFs received $200 billion in new inflows while actively managed funds suffered $124 billion in outflows according to research firm EPFR. That trend has continued in 2016.
Most Investors Are Still Trying To Win A Loser’s Game
Guido Baltussen, Sjoerd van Bekkum, and Zhi Da in a recent academic paper titled “Indexing and Stock Market Serial Dependence Around the World” estimate approximately 7% of U.S. large company stock capitalization as measured by the S&P 500 Index is indexed using ETFs, index funds and futures contracts.
Globally, they estimate just under 3% of global stock market capitalization is indexed.
When I saw that data, I was surprised more investors weren’t indexing. Most investors are still trying to win at a loser’s game. And as a result, most will lag the market averages.
Charles Ellis in a recent interview on Consuelo Mack WealthTrack said, “If you would like to be above average, that’s easy. Index. And you will be clearly, decisively, all most every year, and certainly every decade, comfortably above average.”