
A Professor Who Was Right About Index Funds All Along - carlosgg
http://www.bloomberg.com/news/articles/2016-09-22/the-professor-who-was-right-about-index-funds-all-along
======
jbuzbee
I'm a big believer in index funds and have been putting my money into them for
a long time. But... you have to wonder where this is all ending up as more and
more people move to passive index funds. The power of the market is based on
millions of individual opinions on the price of a company's stock. On average,
over time, these collective opinions will be correct. But say in the extreme
case, it got to the point where _all_ funds were invested passively, we'd lose
this pricing mechanism. Individual stock prices would not reflect the true
value of a company. Instead, the price of each company's stock, healthy and
sick alike, would just rise and fall in synch with the market as a whole. But
then perhaps this would be self-correcting as sophisticated investors would
notice the pricing errors, create managed funds and the cycle would start
anew...

~~~
jganetsk
Warren Buffett says it's OK, and has an excellent explanation for this. If I
recall correctly: imagine you take all the investors in the US economy and put
them in a room. Divide the room in halves. One side contains all the active
investors, the other side contains all the passive investors. If each side
owns roughly half of the economy, their returns will be equal. In that case,
it's better to sit on the side with the lower fees... so one should naturally
sit on the passive side.

Setting Warren Buffett aside, what you neglect to mention is that the stock
market is both a primary and secondary capital market. We can speculate about
how to speculate... whether to be passive or active... but this concerns only
the functionality of the secondary market. There's still primary market
functionality: companies issue stock to raise capital, buyback stock, and
issue dividends. Thus, even if all the investors are passive, there's still
always one active agent in the game: the company itself. And a capitalization-
weighted index is ideally suited for this activity: it automatically shifts
capital away from companies buying back stock (essentially, companies
returning money to investors) to those issuing new stock (essentially,
companies seeking to raise capital).

~~~
joezydeco
Buffett is close to winning a $1 million, 10-year bet he made with the head of
the hedge fund Protege Partners.

The bet was simple. Buffett would invest in a Vanguard S&P 500 index fund, and
the hedge fund could do anything they wanted.

[http://fortune.com/2016/05/11/warren-buffett-hedge-fund-
bet/](http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/)

[http://www.npr.org/2016/03/10/469897691/armed-with-an-
index-...](http://www.npr.org/2016/03/10/469897691/armed-with-an-index-fund-
warren-buffett-is-on-track-to-win-hedge-fund-bet)

~~~
nostromo
The irony of course is that Buffett became one of the world's richest people
by being an active investor.

~~~
yborg
Precisely by being an investor in the old sense, the sense of being a
_businessman_ who allocates capital. He buys entire companies based on his
analysis of their financials and management, and then operates them as
businesses. He tries to take stakes in companies in deals where he holds an
advantage, such as his Goldman Sachs investment. I don't consider him a stock
picker, he's a very shrewd businessman.

~~~
akiselev
He's absolutely a stock picker, not a businessman. That's the definition of
value investing, which is his self proclaimed mode of investment. He looks for
undervalued (by the stockmarket) companies with good cash flow, competent
management, room to grow, etc. and waits until the market price catches up to
his expectations. Meanwhile, he leaves the management alone to do their best
work while reinvesting the cash flow (from dividends) into other undervalued
companies. Most financial institutions were probably undervalued after the
2008 collapse so if Buffet saw an undervalued cash flow positive business,
that's why he invested.

~~~
namlem
Berkshire Hathaway is more involved and hands on than mutual funds. They don't
really micromanage, but they do at least a little bit of basic management.

------
shubhamjain
Being lucky doesn't explain the existence of Renaissance Technologies[1], one
of the very first quant fund companies, which has averaged a 71.8% annual
return from 1994 through mid-2014. In fact, "the fund’s worst year was a 21
percent gain, after subtracting fees". Of course, it's very much of an outlier
— just like Facebook / Google / Uber, if we retrospectively see startup
funding and hedge fund investing.

[1]:
[https://en.wikipedia.org/wiki/Renaissance_Technologies](https://en.wikipedia.org/wiki/Renaissance_Technologies)

~~~
jdmoreira
Luck can be the actual explanation.

By the law of the large numbers, some funds will be a success for quite some
time. Just as some people do win the lottery.

I don't think it's surprising that a couple of funds have a great track
history even if the game is just pure luck.

~~~
kiba
How do you distinguish between pure luck and actual skills?

~~~
michaelcampbell
I believe his point is that you can't, because "actual skills" need not exist.
It might ALL be luck, and outliers will exist. And, their existence doesn't
prove anything about luck or the lack of it.

~~~
Godel_unicode
Conversely, if the difference between luck and skill is unknowable, everyone
who wins might be skillful. As you said, the existence of winners is not
revelatory about the existence of skill.

Related: one can be highly skilled and still lose to someone who is highly
lucky.

------
lordnacho
As someone who's been at hedge funds for over a decade, I often wonder what
I'd do if I just had ordinary access to the markets.

First of all, I have to ask why the equity market should be your benchmark.
And if it's because you think the market generally goes up (not obvious) why
don't you just get leverage on your ETF, so that you basically always beat the
market?

There's another way to beat the market. Smart beta products do variations of
it, but here's a concrete one. Basically my brother had some class about
markets and needed something fast, so I just told him to take the S&P 500, lop
off the top 25% of stocks measured by beta, and scale up the rest. Ta-da.
You'll probably find costs are high, and there's a bunch of admin, but I
suspect there's now a bunch of smart beta ETFs that do the same thing.

As for the EMH, I doubt that it's true. The problem for ordinary people is you
won't be allowed to invest in strategies that are very good.

It makes sense for people on the inside: suppose I have a strategy, with a
Sharpe > 5, that uses very little capital. What am I going to do with that?
Get investors? No, I'll borrow money and take the profits myself.

What does that leave? A bunch of strategies with much less attractive risk
profiles. If I have a Sharpe of around 1, I'm expecting long flat periods.
I'll have to get investors for that. But investors are fickle. One bad year
and they flee, even though you should have one every few years. You could
easily have a couple of losing years with that kind of Sharpe. So what do we
find with that type of shop? They're made of marketing. Box-checker
salespeople who know what to say to institutional investors. IIs who buy IBM.
Or are quick to jump the gun. /rant

------
tedmiston
Disclaimer (since it's buried in the middle): Burton Malkiel is CIO at
Wealthfront, one of the most popular robo-advisors.

------
Animats
It would be interesting to have a fund which was mostly an index fund, but
avoided "losers" based on simple criteria. Picking overpriced losers is easier
than picking winners. (I did that for the first dot-com boom, at
"downside.com".) That's a concept worth testing against historical data.

~~~
lordnacho
That's what smart beta does. You take an index and rejig it slightly to eke
out a somewhat better return.

~~~
countingteeth
It doesn't work though.

------
n72
I recommend Weathfront and Betterment to all my less mathematically inclined
friends. However, if you spend only a few hours getting acquainted with asset
allocation and rebalancing principles, you can do pretty everything that these
services do without their fees.

~~~
mrwinalot
And what do you recommend for your mathematically inclined friends? Any books
you recommend for asset allocation and rebalancing principles?

~~~
toephu2
None, just put your money in an S&P 500 fund. I doubt you will be able to beat
that in the long run anywhere else (Even though there are flaws w/ how the S&P
500 is run now [1]).

[1] [http://www.joshuakennon.com/sp-500s-dirty-little-
secret/](http://www.joshuakennon.com/sp-500s-dirty-little-secret/)

~~~
n72
You can do better by diversifying more. By picking asset classes with a low
correlation, you can reduce risk while increasing return. Hence, you can eek
our more from a simple mix of say:

60% US 30% Int'l 6% REITs 4% Gold

All of this can be bought with low cost mutual funds.

[http://thismatter.com/money/investments/portfolios.htm](http://thismatter.com/money/investments/portfolios.htm)

------
alecco
Yeah, that is all fine a few decades back. But today we are experiencing huge
bubbles caused by central banks.

Stocks are hyper-inflated by QE and near-zero rates. When all that stops it
will pop violently. And sooner or later, they will have to stop. This affects
bonds even more, of course.

------
redsparrow
For Canadians interested in learning about index-based investing I recommend
the Canadian Couch Potato site[0]. If you don't want to put a lot of thought
into it he has some sample portfolios, but also has a lot of resources for
learning more. He's also very good about answering questions in the comments
on his posts.

[0] [http://canadiancouchpotato.com/](http://canadiancouchpotato.com/)

------
grondilu
Me, I don't even believe in funds. If managers are not better than blindfolded
monkeys, why should we even pay them? Just buy diversified stocks, and never
sell unless you need cash.

[https://en.wikipedia.org/wiki/Buy_and_hold](https://en.wikipedia.org/wiki/Buy_and_hold)

~~~
n72
As some of those stocks grow and some shrink, you'll end up overweighted in
certain categories and no longer diversified.

~~~
grondilu
That's negligible, imho.

------
paulpauper
This is good advice. Despite the financial crisis of 2008, the S&P 500 is
still up 80% since 2005 after dividends

------
zachruss92
I love articles like this. I get so frustrated when I see colleagues hire a
financial advisor that sells them a "managed portfolio" that is on-par with
it's market comparable index and/or sell them on products like annuities that
make no financial sense whatsoever. And they charge 1%-1.5% of assets under
management which can be 10x what something like Vanguard would charge you.

Personally, I use Betterment (a competitor to WealthFront) simply becasue I
can set a target asset allocation, and they will balance my portfolio
accordingly. The tax loss harvesting capabilities that both companies offer
are really interesting, theoretically, but there is no empirical evidence
either way as to whether it actually will save you money in the long-run.
Before betterment, I invested in mid-large cap index funds from Vanguard.

------
petra
One you decide to invest in an index fund, what "advice" needs to be automated
?

~~~
nabla9
Risk management and asset allocation that matches changes in your personal
life and your risk profile.

For example: If you know you need to use $200,000 within next two years, you
might want to start moving part of that sum slowly from stock index fund into
other less volatile assets (like bonds etc).

You can do that for yourself approximately without knowing about theory, but
if there is cheap automated system that can provide personal solution based on
portfolio management theory with few bucks, it's can be worth of the small sum
they ask.

------
graycat
> “I can’t believe that the great mass of investors are going to be satisfied
> with an ultimate goal of just achieving average returns.”

Ah, instead he believes he can talk "the vast majority of investors" into
believing that they can significantly beat "average returns"? Hmm. Maybe in
Lake Wobegon.

IIRC the index fund idea, W. Sharpe's work, etc. DOES need stock pickers also
doing their best. Or, for anything with any promise in public a stock market,
there has to be some smarts in there someplace. The reason throwing darts
works so well is because of the stock pickers with the smarts working hard to
buy the winners and sell the losers.

------
esqrama
A discussion between the father of modern finance, Nobel prize winner Gene
Fama, known for the Efficient Markets Hypthesis and his colleague and father
of behavioral economics, Richard Thaler, of Chicago Booth, dissecting this
question. [http://review.chicagobooth.edu/economics/2016/video/are-
mark...](http://review.chicagobooth.edu/economics/2016/video/are-markets-
efficient)

------
dpweb
Returns are used to quantify results, but you can't compare returns between a
hedge fund or trading or market making operation - and a retail customer
putting away their retirement money. Two entirely different operations at work
that result in an overall annual return for each.

In buying a stock, you're buying exposure to a number of factors that affect
the stock price: the company, the money flows into/out of that company's
industry, and the flows in/out for stock market as a whole. In buying an index
you get a more pure exposure to the stock market as a whole. When indexes do
well, its only because money is flowing into it from other asset classes (or
"money printing" by central banks).

Whether we should accept Efficient market hyposisis as explanation of Indexes
beating pros, is a little more complicated. Yes, its true everyone has access
to the same information. In fact, it's illegal to trade on insider
information.

However, when Indexes beat pros, people are quick to say, 'yep.. Efficient
market..', but Indexes have support that the _individual_ stocks or baskets
don't have. A pledged support by the Fed to print money to prop it up.

Take Wells Fargo. Maligned in the news, down stock price, but still a powerful
bank. Buying the stock - not a irrational decision. But, will the Federal Govt
let them go down? They didn't AIG, but who knows. Now imagine the Index
crashes, the Fed steps in. Indexes have the advantage here.

~~~
mikeg1991
Why do you say that we can't compare the results of each? Aren't individual
stock and index's competing within the same environment (same systemic and
unsystemic risk factors)? Difference being that the unsystemic risk is non-
existent.

------
carlosgg
What surprised me the most about the article was that Mr. Malkiel could still
hold an executive position in such a competitive industry (sixth paragraph). I
hope at least _some_ of us here are chief-of-something at the age of _84_. :)

------
kolbe
I'm going to use this as an opportunity to yet again rail against the idea of
indexing. It's a good thing in theory, but like most things, when it's taken
to extremes, it's horrible.

Passive investments wherein the investor takes zero interest in these
investments are and have always been a terrible idea, and nothing in modern
history has facilitated this more than index funds. When you give a friend of
a friend $10,000 to start a company, do you just hand it over no questions
asked and with no follow-up? Or do you try to get engaged with your
investment? Make sure the CEO isn't sitting on his ass collecting a paycheck?
Scrutinize it for potential frauds?

Well, that's what you do in an index fund. Except it's not even a friend of a
friend that you're trusting. It's some group of people who likely live
thousands of miles away who may or may not have an opiate or alcohol addiction
or are complete sociopaths or are just regular humans who know how to legally
take advantage of you when you aren't paying attention.

You want to know why CEO pay is so high? It's because CEOs have no
accountability for raising their pay when investors aren't paying attention to
what they're doing. You want to know why CEOs are taking short-term action to
boost stock prices at the expense of long-term viability? It's because they
care about the short, you care about the long, and you have no voice when
you're in an index fund. You want to know why CEOs are issuing debt to do
stock buybacks? To empire build by paying too much for their competitors? To
play accounting games to boost short-term earnings?

Index funds are the tail that's wagging the dog, and they are going to be a
disaster. And unlike derivatives, which can mess with stock prices but largely
leave the fundamental structure of the company untouched, the dog that's being
wagged here is the viability of globally important corporations that we depend
on.

They were fine when 5% of the market just piggy backed onto the other passive
(though attentive) investors. But now passive and inattentive investors are a
massive proportion of the market.

~~~
edanm
I disagree.

For one thing, there are still _plenty_ of active investors around. The fact
that the less active investors around, the easier it is for them to make
returns, will help the market stable and full of "enough" investors.

It is absurd to worry right now about _not_ having enough finance
professionals, considering just how many people are in the market.

In terms of what's best for a single person deciding where to invest money
right now, indexing seems to provide the best opportunity. It's clear that
most investors will _not_ spend the requisite time tracking companies, nor
should they considering the benefit of specialization.

~~~
kolbe
I appreciate your opinion, but when I see that companies like JNJ are 67%
owned by Mutual Funds and Institutional Investors[1], most of whom are low-
cost and inactive, it tells me we've gone too far.

An I am not advocating for more finance professionals. Paying active managers
to invest for you can cause the same problems I'm talking about. I'm
advocating for personal responsibility and attentiveness.

[1]
[http://finance.yahoo.com/quote/JNJ/holders?p=JNJ](http://finance.yahoo.com/quote/JNJ/holders?p=JNJ)

~~~
edanm
Do you really think the average stock owner has the ability or training to
asses companies, in their spare time?

Honest question. I'd answer no, considering that even trained professionals
aren't so amazing at it.

~~~
AznHisoka
I think we as hackers can use our abilities to analyze certain companies
better than the professionals.

Example 1: track the Google rankings of companies that rely a lot on search
engine traffic. see if any have dropped a lot from a major algorithm change
(i.e. Demand Media)

Example 2: use the Facebook graph API to do the same for companies that rely a
lot on Facebook for traffic.

Example 3: at the end of every month create a profile on weightwatchers.com.
Note the user id number. Use this to extrapolate the number of users that
signed up every month.

Example 4: track the number of websites that installed a JS script for vendors
like Hubspot.

Example 5: every month scrape Ecommerce sites and track the increase % of
reviews for major brands.

~~~
ant6n
These hacks sound like a full time job. How much will I get paid for that?

~~~
AznHisoka
You can always turn it into a business and sell it to hedge funds.

------
nodesocket
Here is a graph of my personal account which I manage myself vs the S&P 500
index. I am currently beating it with gains on the year of 7.3%, but only
thanks to the last couple of strong months. I was deep in the red early on.

[http://imgur.com/a/XHNTZ](http://imgur.com/a/XHNTZ)

~~~
BeetleB
It's not even a year old.

I'm not sure I get your point. _Many_ active funds beat the S&P 500 over 5 or
even 10 years.

------
mark-r
There's an aspect of self-fulfilling prophecy to this. Higher demand leads to
higher prices, and as more money flows into indexes the stocks in those
indexes are going to rise relative to the rest of the market. Thus their
earnings become harder to beat.

~~~
ap22213
Wouldn't that knowledge be accounted for in the individual stock prices?

~~~
smileysteve
Only if people (and funds) continue to not invest solely in index funds, to
which there would be economic incentive, because in the short term, those
might perform better.

------
hiou
Index fund tracking has become successful because one of the goals of US
Government policy is to maintain that things like the S&P 500 continue to go
up over time. If they go down people get voted out of office.

So the index funds have the full force of the US Government watching over
them. This is why economics is not just some math puzzle but often more about
politics and sociology.

~~~
bjterry
The goals of the Federal Reserve are "maximum employment, stable prices, and
moderate long-term interest rates." The real goal, though, is economic growth,
and we just happen to believe that those intermediate goals are good at
serving long-term economic growth.

The prices of stocks are one of the most forward-looking macroeconomic
measures that we have available to us. The better we get at improving long-
term economic growth, the higher stock prices will go, other things being
equal. So basically, if you have good policy, stock prices should always go up
(in real terms). If the Federal Reserve were perfect at preventing recessions
and everyone knew it, stock prices would be higher.

While you would probably not want to make stock index growth the target of
monetary policy because of Goodhart's Law, it is very reasonable to take it
into account as a part of a forecast of how well your policy is working.

------
kelukelugames
Can you put in the title what they were right about? Otherwise it's a
clickbait title.

------
forinti
Brazilian banks have been offering these for decades. It's astonishing that
this could be a novelty in the US.

~~~
maxerickson
The article mentions the Vanguard 500 Index fund and states that it launched 3
years after 1973. So it's hard to understand what you mean when you call it a
novelty in the US.

(without being deeply familiar with the history, I think the Vanguard 500 fund
must have been one of the earliest index funds anywhere, if not the very
first)

~~~
bpicolo
It was the first index fund, yep

