While I believe that index investing has its merits, I do not believe that it is the only means of getting your investment compass to point true north. Advisors who buy into MPT fail to acknowledge the many issues with indexing – so allow me to provide some counterpoints to their argument.
- Let’s start with the philosophical. To say the markets are efficient is to assume that man is infallible. Anyone making that assumption needs to check out the nightly news. The fact is that the markets are made up of a bunch of people (investors) who consistently make irrational decisions based on emotions such as pride, greed, fear, envy, ect. If you are able to eliminate those emotions from investment decisions, it’s very possible to beat the market on a consistent basis. To paraphrase Michael Lewis in his bestseller Moneyball, “Irrationality creates enormous opportunities for those who have the ability to resist it.”
- Let’s continue with the philosophical…The market is a zero sum game, where the average participant performs right at the index prior to expenses. Once you factor in expenses, the average market participant does lose to the market by a slight margin (1-2%). To say that over half the market’s participants don’t beat the index is about as insightful as saying the average NFL record this year was 8-8. (And I’m willing to bet you that next year it will be 8-8 as well.) MPTer’s make the argument than no man or woman can consistently beat the market which is asinine because many have. The performance records of investing legends such as Jim Rogers, George Soros, Warren Buffett and John Templeton prove that beating the market on a consistent basis is attainable.
- Now, let’s proceed to more practical issues with Index Investing, First, it provides no protection against losses in a bear market. When the market loses, you lose.
- MPTer’s often ignore secular trends and investor time frames. (MPTer’s can’t go 5 minutes with out blubbering something about “Over long periods of time, the market does this or that…unfortunately, as my 87 year-old grandmother points out, we don’t all have that much time.) The problem lies in the fact that the market has historically gone very long periods of time and not done squat. For example, it took the market 25 years to recover from the ’29 crash. It wasn’t until 1980, that the S&P bested its 1966 peak (14 years if you’re counting). Japan’s NIKKIE index is still 60% below its 1989 peak. If you’re caught in one of those periods known as a secular bear market, don’t count on any income or appreciation from your equity portfolio for a long time.
There are a lot of bright analysts and economists who make convincing arguments that our equity markets are currently embedded in a long-term secular bear market. Ed Easterling of Crestmont research is one of these such analysts. He says in his paper titled “Markowitz Misunderstood: Modern Portfolio Theory Should Come With a Warning Label”:
Almost unanimously throughout the past century, when the P/E is above average (average is 14.5), subsequent returns are below average. As well, below average P/E’s drive above average returns…So since the current P/E is well above average, shouldn’t the assumption for Markowitz’s model be below average returns?
If you have a 100 year time-frame, index investing is great way to go, but if you have a 20-30 year timeframe, index investing is as much subject to secular trends as any other equity focused strategy.
- Index investing discounts volatility. I wrote a blog post on this subject so feel free to read it if you’re so inclined. The short of it is that realized returns have historically been around 2% less than average returns. Click here for post
- Index investing deemphasizes the importance of inflation: Stocks and bonds do poorly in an inflationary environment. So, if you’re 100% invested in equities and bonds during an inflationary period, the negative impact of sub-par returns in equities will be compounded by a loss in purchasing power. (I think it is interesting that index investing is gaining so much popularity just as inflationary pressures are picking up.)
- THE BIGGEST FLAW OF THEM ALL: Chasing Returns!!! I find it ironic that one of the most prolific arguments made index fund advisors is that “chasing returns” is a loser’s game. Ironically, Index investors are most egregious offenders when it comes to “chasing returns” – they are just far slower to react to trends.
Not a single index investor that I know of recommended real estate in the late 90’s, but now they all include real estate in their portfolios. The biggest proponent of index investing in my hometown of Dallas, TX is a fellow by the name of Scott Burn’s. In the late 90’s, Burns, the creator of the infamous “Couch Potato Portfolio”, couldn’t even spell Real Estate but a few years ago he created the The Four & Five-Fold Portfolios which conveniently include a 20% allocation to REITs. (I’m actually a big fan of Mr. Burns. His work to uncover the insidious evils of variable annuities and all things insurance is priceless.)
Few, if any, MPTer’s currently suggest building a commodity allocation in your portfolio - the only asset class that truly provides negative correlation to equities and bonds. But they will all include a commodity allocation in the next 5 years after the biggest gains of the current commodity secular bull market have already been missed. (A few started recommending commodities prior to the pullback in the space last summer. The pullback was just strong enough to scare these advisors away causing their clients to lose out on the second stage of the secular commodity bull market.)
There is a very basic, fundamental flaw with index investing which is that they use backwards tested data in making forward looking projections. They calculate what would have worked best and assume that that strategy will continue to work best. Unfortunately, the markets work in the exact opposite manner resulting in MPTer’s “buying high” and “selling low”. Furthermore, it results in them adding sectors or asset classes long after the “easy” money has been made. (Ironically, Markowitz’s paper ever-so-briefly addresses this issue but it is largely ignored by MPTer’s who see their strategy as flawless.)
MPTer’s don’t include Commodities because the sector was such a lousy performer over the last two full decades. If they included a commodity allocation, their “projected returns” based on the extrapolation of historical returns would be far less appealing. However, in 2000, the best thing you could have done was move your portfolio to commodities. (Did you know, that the Dow Jones Index is actually down when priced in Gold since it started its rally in Oct of ’02. Click here for post .)