Another Weak Criticism of Indexing

The investment industry has never been kind to index investing, but the criticisms are getting weaker and more desperate.

An article in yesterday’s Globe and Mail gets off to a bad start by suggesting the recent growth in indexing is the result of a marketing campaign: “The financial firms want you to buy the index because they’ve figured out that they can make a good buck selling index-linked products—funds and especially ETFs.”

I suppose it’s true that investment firms like BlackRock and Vanguard want you to buy their products. But the growing popularity of index funds and ETFs has largely been the result of the appalling record of active management, and it has come despite the best efforts of the financial industry, not because of it.

No doubt a small number of firms are “making a good buck” from index funds, but ETF assets in Canada are still about $50 billion, compared with about $800 billion in mutual funds, the vast majority of which are actively managed. That’s about a 6% market share. To suggest the fund industry stands to profit from more passive investing is like arguing the fast food industry is organizing a conspiracy to promote salad.

Staggering costs?

The writer concedes that ETFs have low management fees, but then argues that’s only part of the price tag: “The cost of owning a broad index, particularly the TSX’s, is well hidden but staggering.” The key point, he explains with the help of a Montreal fund manager, is that companies in large-cap indexes like the S&P/TSX 60 are selected mainly because of their size and liquidity. “There’s scant attention paid to the company’s fundamentals, which could be poor or non-existent.” Another problem, the fund manager says, “is that the index is also full of companies that are always looking for new money. Banks, oil and gas, mining—all chronic issuers of capital.”

I have no argument with one of the main points in the article. While most investors value liquidity (the ability to buy or sell an asset easily, with low transaction costs), it does come with a price. Academics agree there is a liquidity premium in the equity markets: you pay extra for the privilege of owning an asset that is easy to sell. That’s one of the reasons small-cap stocks, which can be highly illiquid, have higher expected returns, albeit with higher risk. So when the fund manager says you can improve returns by tilting to smaller companies, he’s right so far as it goes. But it doesn’t go very far.

In with the good, out with the bad

The rest of the article describes how the manager “has trounced the index since 2006,” in part because he runs a relatively small and nimble fund that isn’t bound to an index. We’re told he “invested heavily in Telus Corp. and BCE Inc.,” which earned him “outsized returns” but barely benefited index investors, since these companies make up only a small part of the benchmark. That’s all we’re told about the investment strategy at work here: buy good companies, not bad ones.

At least this is consistent with the author’s April article, which explained that the top 50 companies in the S&P/TSX Composite (which includes over 250 stocks) beat the index handily. Therefore, if you are able “to find the roughly one in five companies whose shares will do well” you can outperform an index fund. And how do you identify those winners? “It takes hard work, skill and common sense.” To hear anything more specific, you have to subscribe to the author’s $200-a-year newsletter.

It’s unfortunate that this passes for debate. There is no data, no research, just a flimsy argument that sounds compelling until you scratch the surface. Index investing is flawed because you get bad companies as well as good ones. It’s possible to beat the market: here’s one guy who did it. Is anyone really swayed by this?

The unanswered questions

If picking winners is so easy, why did 97.3% of Canadian equity manages underperform their benchmarks over the five years ending in 2011? And why, despite the “staggering” costs of large-cap index funds, did the iShares S&P/TSX 60 (XIU) return 8.38% annually over the last 10 years, compared with an average of 5.88% for its actively managed peers? (Figures are from Globefund as of July 31.) Surely this dreadful track record can’t be explained away by saying that fund managers are constrained by liquidity. Might another reason be that picking stocks according to company fundamentals isn’t nearly as easy as it sounds? Or perhaps that XIU’s fee is 10 or 15 times lower than that charged by most money managers?

Indexes and the funds they track are not perfect, and I keep an open mind when it comes to well-reasoned criticism of the strategy and the products. But if you’re going to take on the mountain of evidence that supports indexing, you’re going to have to do better than red herrings and vague anecdotes.