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Upside-down Bash on Index Investing

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On June 19, MarketWatch (owned by The Wall Street Journal) published a blog post authored by J.J. Zhang titled: The downsides to indexed investing. Mr. Zhang is identified as "a chemical engineer and amateur financial adviser who was the winner in MarketWatch's second annual World's Next Great Investing Columnist contest." I don't know how stiff the competition was, but Mr. Zhang should not give up his day job.

As the title of his article suggests, Mr. Zhang isn't a fan of indexing. Here is a rebuttal to his anti-indexing points.

Active Outperformance: Mr. Zhang seeks to "clarify" the studies showing the majority of actively managed funds underperform their benchmarks. For some reason, he focuses on hedge funds and claims the cause of most hedge funds underperformance is fees. He concludes that "[C]alculating returns before fees significantly improves the performance comparison of active funds and, in many cases, show alpha gains."

Let's see how valid that claim is. The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies. The strategies are asset weighted based on the distribution of assets in the hedge fund industry. For the period 2003-2012, the HFRX Global Hedge Fund Index had an annualized return of a puny 1.6 percent and that is net of hedge fund fees. For the same period, the S&P 500 Index had an annualized return of 7.1 percent.

Certainly, the obscene fees charged by these funds create a drag on performance, but is Mr. Zhang really arguing that fees cause such a large gap? And if so, shouldn't that be a different big red flag for investing in these vehicles?

Being Average: Mr. Chang states: "Passive index funds will only give you average results." Really? The odds of a portfolio of 10 equally weighted actively managed funds (rebalanced annually) beating their benchmark over a 10-year period has been calculated to be only 0.055 percent. Over longer time periods, and if you consider tax consequences, the odds are even worse.

I don't know how Mr. Chang defines "average." Beating the returns of more than 99 percent of a comparable portfolio of actively managed funds over the long term does not seem "average" to me.

Financial/commercial literacy: Mr. Chang knocks the intelligence of evidence-based investors when he asserts they ignore "basic research" and "lose sight of what is causing those investment gains and how to respond as the world changes."

The contrary is true. Evidence-based investing is premised on hundreds of academic articles published in peer-reviewed journals. It is taught at the most prestigious business schools in the country, including the Booth School of Business at the University of Chicago. It is embraced by Nobel Laureates in Economics, including William Sharpe, Harry Markowitz, Merton Miller and Daniel Kahneman. Mr. Sharpe summarized his views in this cogent analysis. This research is exhaustively set forth in my books and others authored by Larry Swedroe, Burton Malkiel, William Bernstein, Jason Zweig, Rick Ferri and many others.

If I have noted one consistent thread in blog posts by proponents of active management over the years, it is this: There is rarely a reference to any credible research supporting their views. Mr. Chang is no exception.

Valuation Changes: Mr. Chang asserts indexing focuses on "owning everything regardless of value." He refers to "indiscriminate buying" that can "come back to bite you."

He would be correct if he could cite the authority indicating anyone has the expertise (as opposed to being lucky) to identify prospectively overvalued sectors of the market. But since no one has that expertise, investors are well advised to avoid trying to guess which sectors are likely to underperform in the future. His example of housing in 2008 is dead wrong. Relatively few investors predicted the exact timing of the housing crisis. Evidence-based investors who owned a globally diversified portfolio and stayed the course likely saw their portfolios recover their losses post-2008. Mr. Chang is advocating a form of financial astrology, which is simply gambling. Evidence-based investors understand the science of investing, and focus on those factors they can control, such as their asset allocation, taxes, fees, expenses and diversification.

Choosing the right index: Mr. Chang creates a straw man when he discusses the purported issues in choosing the "right" index. Compelling research has demonstrated the sources of investment returns are largely decided by the decision how much to allocate to small, large, value and growth stocks in the global stock markets.

As a general matter, smaller stocks and value stocks have both a higher expected return and higher risk than larger stocks and growth stocks. The basis for these views is a seminal paper published in 1992 in The Journal of Finance by two prominent professors of finance, Eugene Fama and Kenneth French. The paper is titled: The Cross-Section of Expected Stock Returns. On the fixed income side, both term risk and credit risk are critical factors affecting returns.

Finally, Mr. Chang damns evidence-based investing with faint praise, noting that it is okay "for those who don't have the time to study the markets and do as much research."

Like hedge fund managers and active mutual fund managers?

Dan Solin is the director of investor advocacy for The BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.