Active Management vs. Indexing

BY ROBERT PRESTON

The article “ Fear, Greed and the Madness of Markets ” ( JofA , Apr.03, page 79) was well-done, up to a point. The commentary about emotions driving many investors’ decisions was right on. Buying high and selling low is the norm for many, including most of the highly paid professionals upon whom the public relies.

However, like many investment articles the JofA has published, it was skewed in avoiding mention of the best proven route for the average investor—simple, low-cost index funds. While “the sage of Omaha” is referenced in the article, Warren Buffett’s bias toward index funds is conspicuously avoided in the commentary. Buffett has noted in his annual reports the average investor would be better off avoiding Wall Street and investing in index funds (excluding Berkshire Hathaway Inc. stock, which has outperformed the averages for decades).

Similar to most articles published by the money management community, two sentences in the article, in particular, advocate the need for the average investor to use a professional investment adviser: “Smart investors rely on investment professionals who are highly knowledgeable about behavioral finance—a discipline that carefully analyzes how individual and group psychology influences investor behavior and market trends” and “As many CPAs already know, all it takes is the right adviser—and the right tools.” The inference is, properly selected, active investment advisers have the answers to produce results the average person can’t possibly attain. This is just not so. The average person has at his disposal the means, through index fund investing, to outperform the vast majority of both mutual fund managers and professional advisers, for minimal fees.

Unfortunately, while the article would like the reader to conclude that seeking professional advice is the “right tool” to cure poor investment performance, statistical evidence points to the contrary. More than 80% of mutual funds and money managers fail to outperform the averages such as the S&P 500, Wilshire 5000 and Morgan Stanley emerging markets index—in almost any critical period analyzed. And while they fail to produce, they charge banner fees (over 1% of assets), win or lose. Would you buy a refrigerator or car if the failure rate was predicted at 80% over the life of the appliance with no chance for a refund when the gadget proved to be a lemon? Try getting your fees back from a mutual fund or money manager that produces subpar results—which most do.

While there is a place for stellar active managers in some portfolios, the power and track record of indexing has proven, simplistic as it is, to be the most effective place for the average individual’s investing assets.

A perusal of Vanguard’s Web site, in particular the material put forth by the founder, John Bogle, further documents the power of indexing. Charles Schwab is also a proponent of the concept.

I can understand why much of Wall Street and professional advisers don’t want to tout the real story. The highly paid investment professionals would be flipping hamburgers instead of wallowing in the Hamptons on warm sunny weekends.

I think the JofA does an excellent, consistent job in publishing high-quality content, but why it continues to present articles implying active management is the answer for the individual investor requires some explaining.

Robert Preston, CPA
Danbury, Connecticut

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