Everyone’s Got That Friend
You know that friend, the one who always has a counterargument, an obscure factoid, or tidbit they throw out; the one who’s always looking for a drop-the-mic type moment – the devil’s advocate in all situations. Their comments always sound something like, “I read this article once…” or “This survey actually showed that…” or “Despite the common assumption…” The friend that has a hand full of these trump cards he or she is always ready to drop.
I hope my friends aren’t reading this because they might tell you that I’m “that guy.” 🙂
Nonetheless, dealing with these folks can be quite exhausting, but you’ll often find their rebuttals are weak. They rely on a single data point that can typically be questionable or skewed. Often using a statistic in isolation without context or interpretation.
The Index Card
As you might assume, we have a lot of these people in the world of investing. My personal pet peeve is what I like to call “The Index Card.” This is the person that rails against active management (the hands-on analysis and management of an investment portfolio) and advocates for a passive approach to investing. They quote one study or one “fact” they read to evangelize their investing beliefs around indexing – I call this dropping the index card.
There are indeed countless credible studies that show the low success rate of active managers versus their relative indices. Further, many of these studies show a high correlation between cost and performance, with higher costs correlating to lower performance.
So, what’s the conclusion we draw from this? For my indexing enthusiasts, the conclusion is that indexing is a superior strategy to all other investing strategies. Let me offer a different thought and perhaps pull back the curtain a bit more on what these studies are actually telling us.
If you were to take a random sample of active managers, you might be surprised to find how similar each of their portfolios looks to the index they benchmark themselves to. This is so common the industry actually has a metric called “Tracking Error” to show you how closely a portfolio tracks the performance of the index. It’s important to remind ourselves who actually manages these active portfolios. These are real people who have real mortgages, real families, and a real fear of losing their job. Investors aren’t the most patient bunch, so high tracking error can be a risky move for a portfolio manager – which means most take the safe route and “hug” the index. What happens when you have a population of index huggers charging a fee higher than the relative index fund? You get a high population of underperformance.
Sin a Little…
Most readers of investment news and research will not take the time to craft the fact pattern I outlined above. So, they hold tight to the confirming evidence they choose and resolve to be an index investor. Well, at least they call themselves such.
In all my years, in all my conversations, of all the people I’ve interacted with, I have not met one pure indexer. I’m not exaggerating, I have not met one. The index gospel would tell you that the cardinal sin would be to own anything outside of just the simple vanilla index fund. Yet, every “indexer” I’ve met likes to sin a little.
You hear their zealous preach for indexing, and then you look under the hood of their portfolio, and you find skew. A slight skew towards more value-type companies or a tilt towards smaller capitalization companies, or a slight overweight towards international companies. They take their original argument, and they essentially taint it with their bias related to some other research they found convincing.
As much of an oxymoron, this is, most “indexers” have actively managed allocations made up of passive strategies.
Are You Tracking?
As I mentioned earlier, investors are quite impatient, and they are always highly focused on doing better than their neighbors today. Investors welcome tracking errors when the results favor their strategy but find it repulsive when it results in them trailing their neighbor’s results. Maybe they should be reminded that none of their neighbors are ACTUALLY indexing 🙂
Here’s the reality, if you don’t hug the index and your convictions lead you elsewhere, your results will be different.
Of course, Warren Buffett has refined his craft over the years, but his overarching style and approach have been consistent – his convictions and discipline set him apart from the rest. Warren Buffett trailed the index (S&P 500) by 1,600 basis points (16%) in 2020. This is the type of experience that makes investors cringe. In 2022, as of this writing, Buffett’s holding company is leading the index by nearly 2,100 basis points. This is a high tracking error, high conviction, and ACTIVE approach to investing.
Buffett’s Bad Advice
I admire Mr. Buffett for his incredible track record and the endless wisdom he shares with the investing public, but there is one little piece of bad advice that he often promotes. In interviews, Warren consistently states that most investors should just buy the S&P 500 index fund. If this seems like odd advice coming from a man that would be on the Mt. Rushmore of active management, that is because it is indeed odd or misplaced advice.
Warren Buffett and his team put an extreme amount of attention and focus on analyzing businesses – both public and private – to prudently invest their personal monies and the money of their investors. In 1996, Buffett’s holding company even introduced “B” shares to make his strategy more accessible to all investors.
For me, I am much more interested in what someone actually does – where they put their actual money – versus what they say I should do. The whole “Do as I say, not as I do” thing doesn’t really sit well with me.
But, hey, nobody is perfect 🙂
A Convenient Argument
I’ll wrap us up here, the advocation for indexing is also a convenient argument.
Think about the history of the financial advice industry. It all started with the stockbroker. Your broker had access to all the information and was your best source for advice on what stocks to buy and sell. Eventually, the misaligned incentives associated with commissioned transactions gave way to the financial planner. Investors now expected fiduciary-type advice on both their investment portfolio and financial planning needs. They (the consumer) wanted guidance on everything from taxes to retirement to estate planning. The industry pendulum swung, and practitioners gave more focus to planning and less focus on investments. So much so that advisors began to outsource their client’s investment management needs to turnkey solutions. These supply chain investment management providers are literally called TAMPs or Turnkey Asset Management Programs.
Anything labeled “turnkey” is usually code language for a burdensome task that someone – in this case, the advisor – desires to hand off. So, the industry did just that, they’ve let the art of investment management nearly become extinct and justified the death sentence in the name of indexing.
As I mentioned, a convenient argument when it allows you to opt-out of learning one of the more challenging parts of our trade, opting into a turnkey solution, and essentially short cutting your professional obligations.
Too harsh? Maybe. But, as for The Bahnsen Group, we are committed to employing a robust team of analysts and other investment professionals to oversee an actively managed investment portfolio. We desire to know the businesses we own intimately, and we are thankful to be gleaning the benefits allotted to us as co-owners of some of the most incredible companies in the world.
As our founder, David Bahnsen, often says, “To that end, we work.”