one who tries to do it themselves.
Oh, a few people will succeed: Warren
Buffett, Klarman and some others perhaps.
There are meaningful studies that show
that value and momentum have
persistence, and over many years can produce
above-average returns. But the odds of
identifying the managers who can successfully deliver those returns are not great.
The typical criticisms of indexing have
always felt slightly inadequate. Consider
just a few: The top heaviness of indexes
makes them dangerous during bubbles.
We’ve had two massive market bubbles
and crashes since 2000 and indexes have
come out looking just fine.
One recent blogger suggested that the
last trillion dollars coming into index funds
was “hot money” — i.e., investors chasing performance — and this hot money
would rush out at the first sign of trouble,
leading to a market collapse. That may be
so, but I doubt any meaningful amount
of money coming out of index funds will
be flowing back to active managers any
time soon. That ship has sailed.
Most observers whose thinking aligns
with Ellis and Bogle conclude that investors who have yet to jump on the indexing
bandwagon should climb aboard soon.
After all, how many more data points do
they need to convince themselves of its
Whether you’re an individual investor, an advisor or have responsibility for
institutional assets, when you look out at
the investment alternatives, your objective
is to make good decisions — ones that, irrelevant to the outcome, will continue to
look sensible and well-reasoned, and most
important, serve your best interests.
About 10 years ago, I noticed that more
and more investors and observers were
thinking about their choices in a binary
fashion: Should I be active or should I index? Over the last three to five years that
thinking has narrowed to: Why shouldn’t
I index? It’s a logical question.
With indexing, you have a strategy that
is simple, cheap, tax-efficient, available to
everyone and capable of handling almost any
sum of money — one with historical returns
that beat most of active alternatives. With
active investing, you face a complex array
of choices — different strategies, different
managers, unpredictable tax consequences,
costs many times that of index funds and
a history of below-average returns.
Is it any wonder that the move to indexing is accelerating? Rarely have I seen an
investment choice so self-evident and so
obvious. I have tried to be clear and objective
about this issue. There is no debate about
the academic and intellectual foundation
of indexing, its performance advantage, its
simplicity, its cost-advantage and its ease
of implementation. Every investor who
decides to index is making a completely
rational choice for him or herself.
Future of Indexing
If investing didn’t exist on a continuum,
this would be the logical end-point of the
discussion. But investing does exist on a
continuum. What was popular can fall into
disfavor. What was ignored can become
important. What works can stop working.
Something that dominates the minds of investors can become irrelevant. Good markets
can become bad markets. It goes on and on.
Unfortunately, predicting or even identifying these transitions is almost impossible.
The one exception to this is human behavior.
Unlike the performance warning plastered
on every piece of investment literature, past
behavior does guarantee future behavior.
Of course, individuals can and do learn
lessons, and can avoid repeating both
their own and others’ mistakes. Collectively, however, investors have memories
like sieves, perpetuating the market version of “Groundhog Day:” repeating the
mistakes of past investors, who repeated
the mistakes of investors before them, ad
infinitum, ad nauseum.
If we agree that indexing is the most
perfectly suited investment strategy for
today’s market environment and that the
more active investors strive to beat the
market, the more advantage they have over
indexers, then the future success and/or
demise of indexing is squarely in the hands
of those who hope to benefit from it.
What then is the probability that index-
ers will engage in behavior like that of past
investors? Will indexing be the exception,
and become the first popular investment
strategy in history to avoid attracting too
much money? Or will its future be more fa-
miliar (as described by Jeremy Grantham)
— “excellent fundamentals irrationally ex-
trapolated”? If you’re playing the odds, this is
not a question of if, just a question of when.
How can I be so sure that too many in-
vestors will climb aboard the indexing train?
Well, I can’t be 100% sure. No one can be.
But there are just too many examples of
participants whose livelihood came from a
shared resource — grazing lands, fish habi-
tats, waterways, etc. — who, in the process
of acting in their economic self-interest,
destroyed the source of the very benefits
they were enjoying. Known as the “tragedy
of the commons,” it best explains both the
behavior and logical implications of too
many investors with too much money chas-
ing a huge but still not unlimited resource.
Whatever is in the minds of investors who
are attracted to indexing today, it doesn’t
have the goal of creating an ecosystem so
antithetical to their interests that it could
endanger the very market environment that
they hope to exploit. And yet that is exactly
the collective direction they are taking.
Will indexers self-regulate and accept
lower returns with expensive active al-
ternatives? Or will investment behavior
simply repeat itself, as one investor after
another capitulates to indexing and its
increasingly self-evident benefits?
Indexing taught us that successful investing can be simple. But investors need
to remind themselves, regularly, that it is
never easy. As Howard Marks brilliantly
said, “The riskiest thing in the world is the
widespread belief that there is no risk.”
Marshall Jaffe is managing partner of Jaffe
Asset Management, an investment advisory
firm in Beverly Hills, California.