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The end of indexing?

Chris Farrell Oct 31, 2008

Question: Chris, My wife and I have been following your advice (and the advice of many others) for retirement investing for years. We have about 15 years until we hope to retire (of course, hope is the operative word there, since the gallows humor going around these days is that “80 is the new 65”). Basically, we buy broadly diversified index funds on a monthly, dollar-cost averaged basis, and we hold (about 65% equities and 35% bonds). I’m watching the beginning of yet another bloodbath day for the stock market this morning (October 24) and I’ve recently started to question this buy and hold strategy. It really hasn’t work for the S & P over the last decade or so. With pundits throwing around opinions like “there won’t be another secular bull market for a long time, but there will be cyclical bull markets in the coming years,” isn’t an active buy and sell approach a better one, and, if so, how does the average investor participate in that approach? Richard, Bozeman, MT

Answer: Another gallows joke I’ve heard is that a “walker” is the new corporate benefit.

On to your question: One personal finance lesson not to take away from recent experience is that indexing is a mistake. Yes, I imagine you’re hearing talk about how professional money managers can avoid the investment carnage by trading adroitly. That’s reminiscent, at least to me, of comedian Will Rogers famous quip, “Buy stocks that are going up. After they have done that, sell them. If they ain’t going to go up, don’t have bought them.” Or, as Rex Sinquefield, chairman and chief investment officer at Dimensional Fund Advisors, once said: “There are three classes of people who do not believe that markets work: the Cubans, the North Koreans, and active managers.”

There’s no reason to believe that actively managed mutual funds will systematically do better after fees in this market–or any other market for that matter. (And a lot of hedge funds–managed by the best and brightest–are getting wiped out these days. It’s one reason the stock market is so volatile.) In a sense, Wall Street takes its cut everytime an actively traded mutual fund or managed account makes a bet, and their take slices into returns. “Meanwhile, Wall Street’s Pied Pipers of Performance will have encouraged the futile hopes of the family. … will be assured that they all can achieve above-average investment performance – but only by paying ever-higher fees. Call this promise the adult version of Lake Woebegon.”

Who wrote that? Ralph Nader? No, it was Warren Buffett, the greatest stock picker in modern times. He’s spot on.

The expense ratios on index funds are razor thin–ranging between, say, 0.10% and 0.20% for a broad-based equity index fund vs. 1.0% to 1.5% for a comparable actively managed funds. Over the years, that fee advantage adds up. Then there is the cost of time. You have to ferret out good mutual fund money managers, or pick out stocks on your own, and then monitor them closely. That’s tough to do. In a letter to shareholders Buffett made a strong case for the kind of value oriented stock picking approach that he practices–which is knowledgeably poring over balance sheets and studying management. But if truly understanding a company isn’t your passion, then use index funds, he advised. “By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals,” Buffett wrote. “Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

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