Reasons to Avoid Index Funds - YouTube

- I generally assume that most

of you watching these videos are already fully

on board with the idea that index investing makes sense.

While stock picking

and actively managed funds should be avoided

like the plague.

Most Canadians are apparently not on board with that idea.

As at the end of 2018, only 11.5%

of Canadian investment fund assets that is mutual fund

and ETF assets domiciled in Canada

were invested in index funds.

Clearly more people in Canada

should subscribe to my channel.

I'm Ben Felix Portfolio Manager at PWL Capital.

In this episode of "Common Sense Investing"

I'm going to tell you

that there are no good reasons to avoid index funds.

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Anecdotally, I can tell you that there are lots

of financial advisors out there who genuinely believe

that index funds are terrible investments.

They have their reasons to believe this.

And I'm willing to bet that it's this type of misinformation

from supposedly financial professionals that is

keeping so many Canadian dollars invested

in actively managed funds.

Let's start with the classic fallback line for any advocate

of active money management.

Index funds are risky.

The premise of this argument is

that when you own the whole entire market, you will get all

of the ups and all of the downs that the market delivers.

The alternative would of course be investing

with an active manager that is able to feel out

the market and use their analysis

and intuition to protect you from a downturn.

The active management story sounds way better

than writing out, down markets with index funds.

But the story does not hold up

when we look at the data.

Vanguard did a study in 2018

to look at the performance of active managers

in bull markets when stocks are doing well,

and in bear markets, when stocks are doing poorly.

Critics of index funds would suggest

that active managers should outperform the index

in a bear market.

The data show that more than 50%

of active managers outperform the index

in some historical bear markets, but in other bear markets

less than 50% manage to be the index.

This should not instill confidence in anyone betting

on active management to save them in a downmarket.

If active funds do not offer any protection

when stocks fall, then there is no basis to say

that index funds are a relatively risky investment.

Active management also introduces

a whole other element of risk.

We know that the market as a whole is risky.

It goes up and down in value

as investors expectations about the future change.

For taking on the risk of the market,

investors expect a positive return.

In other words, the risk of the market is a priced risk.

An active manager is still taking on market risk

but they're also taking on active risk.

The risk that their bets will end up paying off.

Active risk is not a priced risk.

I would argue that active management is far riskier

than index investing because active management

introduces an additional level of risk.

And it is a type

of risk that does not have a positive expected return.

Another common reason to avoid index funds is

that you get no control over your holdings.

You end up buying all of the bad stocks

along with the good ones.

With the right active manager,

you will only get the good stocks

while avoiding the bad ones.

This is another great story without any data to back it up.

The problem with only picking the good stocks is

that there is no way to tell what a good stock is.

There is a massive difference between the quality

of a company and the quality of its stock returns.

For example, from 2010 through 2017

a time when and Google, Apple, Amazon

and a Netflix shares were on a massive growth path.

Domino's pizza had stock returns that dominated all

of the tech giants.

It takes some serious predictive ability to successfully bet

on a company like Domino's.

This is not a small issue either.

My example is descriptive of how stock returns work.

Of the roughly 26,000 stocks that appeared

in the CRSP database,

a comprehensive database of U.S. stocks

from 1926 through 2015, only 1000 of them were responsible

for all of the market returns in excess of treasury bills

over that time period.

That was like finding a needle in a haystack.

We can think about this issue another way.

Global stocks as whole returned 8%

per year on average from 1994 through 2017

if you missed the top 10% of performers each year

your average return drops to 3.6% per year.

It is easy for an active manager to say

that indexing results and owning all

of the good and bad stocks.

What they're not able to tell you is which stocks are good

and which ones are bad.

The reality is that it is a relatively small number

of stocks that drive the market's returns.

And it is next to impossible to consistently

identify those stocks at least ahead of time.

When proponents of active management give these reasons

for avoiding index funds, it is always

on the basis that active management is a superior.

This is where the data comes in.

The SPIVA Scorecard shows us the percentage

of funds in each category that were able to

beat their benchmark index over a given time period.

The SPIVA Canada mid-year 2018 report shows

that the vast majority of actively managed funds

were unable to beat their benchmark index

over one, three, five, and ten-year periods.

Of course, the rebuttal to this data is that

but he would invest with any old active manager.

Smart investors only invest with skilled active managers.

If you can find a skilled manager,

index funds don't make sense.

Let's dig into that for a moment.

The idea that a successful active manager might be skilled

needs to be considered alongside the fact

that their success may have been due to luck.

Even over long periods of time

some active managers will beat the market

due to luck rather than skill.

This makes the process of finding

a skilled manager exceptionally challenging.

In a 1997 paper

Mark Carhartt demonstrated that any persistence

in mutual fund outperformance was not due to

manager's skill, but due to exposure to the common factors

in stock returns, including size value and momentum.

The abstract to the paper concludes the results

do not support the existence of skilled

or informed mutual fund portfolio managers.

In 2010 Eugene Fama and Kenneth French,

again studied mutual funds

in their paper luck versus skill in the cross section

of mutual fund returns and found that before costs

there are both skilled and unskilled managers

but the skilled managers are not skilled enough

to cover their own costs.

Over the years, there have been many anecdotal examples

of superstar fund managers who flamed

out hard to finish their career, were they lucky or skilled?

If they were skilled, why did their skill run out?

Take David Baker who managed the 44 of Wall Street Fund to

be the top performing us equity mutual fund in the 1970s.

He even beat the famed Magellan Fund managed by Peter Lynch

over that time period.

For the following decade

the 44 Wall Street Fund was the worst performing fund

with investors losing a 73% for the full time period

while the S&P 500 grew 17.6% per year on average.

Or how about the Legg Mason Value Trust Fund managed

by Bill Miller.

He beat the S&P 500

for 15 consecutive years ending in 2005.

Starting in 2006,

he led the fund to five years of mostly awful performance

before handing the management over to a new manager.

None of this should come as a surprise statistically

it would take 36 years of 2% alpha.

That is 2% of excess risk adjusted performance

with a standard deviation of alpha

of 6% for manager's skill to be statistically significant

at a 95% level of confidence.

10 or 15 years about performance

it tells us almost nothing.

With no way to identify skilled managers ahead of time,

the argument that skilled managers make index

funds obsolete does not make any sense.

Before anyone says what about Warren Buffet,

please check out my last video

which covered the Oracle of Omaha in detail.

Has anyone tried to convince you

that index funds are bad investments?

Tell me about it in the comments.

Thanks for watching.

My name is Ben Felix of PWL Capital

and this is "Common Sense Investing".

If you enjoyed this video, please share it with

someone that you think would benefit from the information.

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