How to argue with a Couch Potato

Last week, Advisor.ca published a debate under the heading “Faceoff: Index, friend or foe?” The arguments against passive investing should be helpful to mutual fund salespeople trying desperately to defend their turf in the face of overwhelming evidence that they are failing investors. Here’s a summary of the arguments in the article, along with some helpful tips:

1. Imply that large funds are more likely to outperform

Example: “The best-performing mutual funds are usually the ones with the most AUM, a fact glossed over by promoters of the passive option.”

Start by implying that investors who chose funds with more assets under management (AUM) have a greater probability of outperformance. This won’t be easy, because your client might notice you’ve got it backwards. He might explain how funds grow in assets after they have performed well, because advisors chase performance. He might explain the concept of survivorship bias. Finally, he might ask you for data showing a correlation between fund size and future performance, which will be awkward, because there is none.

2. Explain that your fund manager is smarter than the market

Example: “Passive investing presupposes that markets reflect all relevant knowledge. Yet that’s not true. Active managers dig deeper and find things out about companies through face-to-face interviews, for example.”

Tell your client the secret to beating the market is research. Your client might point out that thousands of  analysts are doing this, and that their collective judgment (the market price of the stock) is the most reliable estimate of a company’s worth. You should deny this and explain that you can learn more in a face-to-face interview with management. After all, executives are always scrupulously honest about their company’s inner workings and have no vested interest in putting a rosy spin on their situation.

3. Invoke the name of Nortel

Example: “At its peak Nortel represented 31% of the index, so if you’re pinned to the index with a passive strategy you’ve just gone over the hump on a roller coaster — start screaming.”

Yes, we know this example is 13 years old (Nortel peaked in 2000), but it still has some legs. You just need to ignore that the S&P/TSX Capped Composite Index, widely tracked by Canadian index funds and ETFs, imposes a limit of 10% on any individual holding.

4. Name a couple of random people who made one good call

Example: “Alan Radlo (now at CI Investments) and Kim Shannon (who now markets Sionna funds through Brandes Investment Partners) both predicted the Nortel collapse when the price was north of $85.”

Index investors believe every active managers is always wrong, and there are no examples of individuals who made an accurate forecast about a company or the economy. You need to be ready with compelling anecdotes like this to prove them wrong. It helps to mention Nortel again (really, it never gets old), but you can also invoke Black Monday or the 2008 crash for variety.

5. Blame ETFs for investor stupidity

Example: “Many people are buying ETFs on speculation. They’re chasing performance by playing the market, and that’s a disaster waiting to happen. If you’re buying and selling intra-day, you’re trading, not investing.”

Passive investing doesn’t work because some speculators use ETFs recklessly. If your client doesn’t understand this, try a different analogy. For example, some people get drunk and drive their Honda Civics 180 kph, eventually crashing and dying fiery deaths. Therefore, Honda Civics are dangerous.

6. Reveal a staggering ignorance about how ETFs work

Example: “As a stock rises in market cap and is adjusted, the index adjusts the weighting up or down, and the ETF follows — it’s forced to react after the active managers have made their money. This knee-jerk action pushes or pulls the market for that stock up or down after the party is over. When the fall is precipitous, the pain is greater.”

This line of reasoning will be particularly influential with clients who have absolutely no clue how an ETF works, which is a common strategy. The important fact to ignore is that cap-weighted ETFs don’t “react” to anything: if an individual stock in the index rises or falls sharply, the fund’s value will simply go up or down accordingly. There is no buying or selling unless the company is added or removed from the benchmark, so an index fund cannot “push or pull the market for that stock up or down.” Make sure you include the part about active managers having already “made their money”: it’s a nice rhetorical flourish.

7. Argue that if something is popular, it must be good

Example: “Passive investments have been around for 30 years, yet account for only 10% of the industry. Wouldn’t more people be invested in them if they were so effective?”

This is a deep insight into humanity: if only a small number of people do something, it must be because it’s bad. There are many other examples. You might point out that junk food is a better choice than vegetables: after all, if broccoli is so healthy, why are people more likely to eat potato chips?