Should you try to outperform the markets or invest in an index fund?

  • Matus

Index funds have grown to represent a large part of financial markets from once obscure instruments. Today, the Wall Street Journal reported that track broad U.S. equity indices have hit $4.27 trillion in assets (at the end of August) compared to $4.25 trillion at active funds that try to beat the market. Is it worth investing one's time trying to outsmart Wall Street or is it better to invest cheaply in index funds and achieve average returns?

Let me give you an analogy. How many people in the world play football (soccer) and make it into the big leagues? How many of the tens of millions eventually get to play at Maracana stadium or win the FIFA World cup? Only a tiny minority of the total ever get to the top, which is the same in any sport or endeavor.

Beating the index over a long time horizon is the equivalent of that. Only a handful of active investors out of the tens or hundreds of thousands manage to do that. Why do people try when they know the odds are so much against them? Why do people play football, if they know that chances of them getting to FC Barcelona or AC Milan are slim? Maybe because they enjoy the game, and maybe if something looks almost impossible, it doesn’t prevent them from trying.

The rewards of beating an index are huge. There are hundreds of billions of dollars (and maybe even more) that are chasing the next Warren Buffett or Peter Lynch, An investment manager capable of delivering alpha with large sums of money is basically worth billions. As long as that’s true, there will always be people that will try to beat the S&P500 or whatever other index.

Buying an index fund is a perfectly fine way of investing and there is nothing wrong with it. The vast majority of investors should take this route, as the fees are very low, effort is minimal and the returns are still very good.

But if you enjoy the game of investing, that is analyzing and valuing businesses, you can’t resist the itch of trying to outperform and getting to the top. Because it’s so much fun and the eventual rewards are so large. Investing is hard, and outperforming an index is incredibly hard, it requires insane effort, lot of reading and nerves of steel.

Another point is that professional investors are subject to many biases and rules , that influence their behavior and undermine their perfromance.

  1. Incentives - many institutional investors and incentivized to not deviate from the benchmark. That is if they do invest in some unconventional idea or company and it fails, they can get fired. Whereas if they succeed, they don’t get much benefit from it. If you are a portfolio manager and you buy Apple and it goes down, you don’t get much blame as everyone owns it. But if you buy an unknown internet company in China and it goes down, you will feel the heat. So you just mimic the index, a strategy called “closet indexing”.
  2. Institutional imperative - In his 1989 letter to shareholders, Warren Buffett describes this problem: “(1) As if governed by Newton's First Law Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.” Number 4 is especially applicable to investment management firms, that often behave like lemmings.
  3. Sales and admin - Portfolio managers spend a lot of time talking and reporting to existing and potential clients, as well as to regulators and bosses. This takes too much effort, which detracts from their investment performance. If you have to constantly worry about what clients will think or say, it’s very hard to focus on finding great opportunitites. That’s also one of the reasons why hedge fund manager Bill Ackman stepped away from the limelight and stopped his fund marketing efforts. Bad funds focus on marketing, good funds focus on performance, which speaks for itself.
  4. Lack of passion - for many investment professionals, investing is just a job. They do it to make money and provide for their families and themselves. They do what’s required of them, but never more. The best investors are fanatics, who do much deeper research and genuinely enjoy the game of investing.
  5. Amount of money - large institutional investors manage tens and hundreds of billions of dollars. As a result they focus mostly on large and liquid companies, which means that smaller ones are overlooked and sometimes inefficiently priced. An individual investor thus has a larger opportunity set plus the ability to get in and out of positions quickly in case something happens.
  6. Temperament - investors are humain beings, and are thus influenced by fear and greed, the two worst enemies. These cause us to buy overpriced and popular stocks and sell stocks during panics or downturns. Best investors take emotions out of the game and focus on fundamentals of individual companies and their intrinsic value. Even when you buy an index fund, you are still subject to these emotions and most people buy and sell precisely at the wrong time.

Thus if you are an individual and passionate investor, who manages a smaller amount of money and you don’t have to make sales pitches to clients and are not influenced by what others are doing or thinking, you actually have a decent chance of outperforming professional investors and perhaps indices as well.