My financial advisor says he can beat index funds. I also read an article saying that index funds are worse than Marxism. Why should I invest in index funds if they’re ruining the economy and are so easy to beat anyway?
Explore This IssueACEP Now: Vol 43 – No 02 – February 2024
There are many lies told about index funds, usually by people and companies who profit from pushing investors into alternative methods of investing, such as actively managed mutual funds or whole life insurance. Most of the lies are easily refuted using prominent and publicly available data. Others are nonsensical and silly. In the end, the informed investor generally concludes, with a nod to Winston Churchill, that index funds are the worst way to invest except for all of the other ways.
One of the most prominent lies is that it is easy to beat the market and the index funds that faithfully track its return. The data refuting this lie are extremely robust. Consider the SPIVA Scorecard published twice a year by Standard and Poors. It demonstrates that over a 20-year time period, fewer than one out of 10 actively managed mutual funds beats the market. We’re not just talking about the big U.S. stocks like Exxon and Amazon, either. In every type of publicly traded investment including U.S. stocks, international stocks, small stocks, growth stocks, value stocks, real estate investment trusts, and every type of bond, the low-cost index funds trounce similar actively managed funds. They do so in bull markets and bear markets. In fact, many of the actively managed funds don’t even finish the race. In the most recent scorecard, over the last 20 years, two-thirds of the mutual funds were doing so poorly that they were closed or merged into another fund. This data doesn’t even include the effect of investment-related taxes. Index funds are notoriously tax-efficient and, when investing outside of tax-protected retirement accounts, this provides a further advantage to index funds.
If the full-time, highly educated, Wall Street professionals running actively managed mutual funds can’t beat the index with a dedicated, highly trained team of analysts and the best computers money can buy, what hope do you have? Or your “financial guy” who was selling cars two years ago? I don’t want to say the answer is zero percent, but it certainly rounds there.
The data for hedge funds isn’t much better. Warren Buffett famously bet hedge fund manager Ted Seides that the S&P 500 Index Fund could beat a diversified portfolio of hedge funds over 10 years. Despite the Global Financial Crisis of 2008 occurring at the beginning of the bet, the index fund trounced the hedge funds. Before the bet was even over, Mr. Seides conceded defeat. He was behind a cumulative 85 percent to 22 percent in year nine of the bet. While in some ways it was an apples-to-oranges comparison, it certainly did not demonstrate that hedge funds have better returns than just buying all of the stocks using an index fund.
Speaking of apples and oranges, another favorite trick of those trying to “prove” that active management works is to compare the returns of a portfolio of small cap stocks or value stocks to an index composed of large or growth stocks. Unsophisticated investors might not be able to see through these techniques since they have never heard of an index beyond the Dow Jones or S&P 500. Or maybe they point to somebody like Warren Buffett, who has an exceptional, multi-decade record of beating the market, and say, “See! Warren Buffett beat the market, so it can’t be that hard.” It’s a big step from saying Buffett beat the market to your brother-in-law trained in insurance sales being able to do it. Statistically, sheer random chance should have produced a lot more “Warren Buffetts” than currently exist.
Others warn that index funds have become so popular that they are certain to cause an apocalyptic market meltdown. Indeed, something between 15 percent and 40 percent of the money invested in the stock market is invested via index funds (both traditional mutual funds and exchange traded funds or ETFs). In 2022, for the first time ever, there was more money invested in index mutual funds than actively managed mutual funds. It seems that most retail investors and their advisors may be getting the message. However, some people worry, or at least have a vested interest in getting retail investors to worry, that all that money being blindly invested in index funds will somehow result in some sort of deflating market bubble or other cataclysm. The market is perfectly capable of pricing its securities even with almost all of its money invested passively. Only a tiny fraction of the daily trading on the market is done by the “buy and hold” index funds who buy blindly anyway. The rest of it is done by active managers and traders trying to eke out a bit of extra return. That is plenty of analysis and competitive pricing to ensure markets remain efficient enough that investing passively is still the right move. Those who try to convince you otherwise usually have a serious conflict of interest.
Evidence-based investors have no choice but to conclude that, barring possession of a crystal ball, low-cost, broadly diversified, index funds are the best way to invest in stocks. These funds are tax-efficient, avoid style drift, and eliminate manager risk. While they will be just as volatile as the stock market, in the long run they will guarantee you market returns. If you couple market returns with a physician income and a moderate savings rate, you should be able to accomplish all of your reasonable financial goals, and that’s what the one-player game of investing is all about.
I’m looking forward to seeing as many of you as possible at the ACEP Scientific Assembly this year in Las Vegas. I’ll be giving a talk aimed at graduating residents and new attendings on Monday morning, but ACEP is also sponsoring an all-day workshop on Saturday before the conference starts. More details on that soon, but if you’re not confident in your current financial plan, come to ACEP24 and we’ll help you build one that you can be confident will allow you to reach your goals.
Dr. Dahle blogs at www.whitecoatinvestor.com/classic-blog/ and is a best-selling author and podcaster. He is not a licensed financial adviser, accountant, or attorney, and recommends you consult with your own advisers prior to acting on any information you read here.